Get Complete eBook Download By email at student.support@hotmail.com
FUNDAMENTALS OF ACCOUNTING
AND FINANCIAL MANAGEMENT
KEN TROTMAN
VICTORIA CLOUT
KERRY HUMPHREYS
KATE MORGAN
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
FUNDAMENTALS
OF ACCOUNTING
AND FINANCIAL
MANAGEMENT
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
FUNDAMENTALS
OF ACCOUNTING
AND FINANCIAL
MANAGEMENT
KEN TROTMAN
KERRY HUMPHREYS
VICTORIA CLOUT KATE MORGAN
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Fundamentals of accounting and financial management
© 2023 Cengage Learning Australia Pty Limited
8th Edition
Ken Trotman
Copyright Notice
Kerry Humphreys
This Work is copyright. No part of this Work may be reproduced, stored in a
Victoria Clout
retrieval system, or transmitted in any form or by any means without prior
Kate Morgan
written permission of the Publisher. Except as permitted under the
CopyrightAct1968, for example any fair dealing for the purposes of private study,
research, criticism or review, subject to certain limitations. These limitations
Portfolio manager: Fiona Hammond
include: Restricting the copying to a maximum of one chapter or 10% of this
Product manager: Rachael Pictor
book, whichever is greater; providing an appropriate notice and warning with the
Content developer: Eleanor Yeoell
copies of the Work disseminated; taking all reasonable steps to limit access to
Senior project editor: Nathan Katz
these copies to people authorised to receive these copies; ensuring you hold the
Cover designer: Chris Starr
appropriate Licences issued by the CopyrightAgencyLimited (“CAL”), supply a
Text designer: Linda Davidson
remuneration notice to CAL and pay any required fees. For details of CAL licences
Permissions/Photo researcher: Helen Mammides
and remuneration notices please contact CAL at Level 11, 66 Goulburn Street,
Editor: Kate McGregor
Sydney NSW 2000, Tel:(02)93947600, Fax:(02)93947601
Proofreader: James Anderson
Email:info@copyright.com.au
Indexer: Max McMaster
Website:www.copyright.com.au
Art direction: Linda Davidson
Typeset by KnowledgeWorks Global Ltd.
For product information and technology assistance,
in Australia call 1300 790 853;
in New Zealand call 0800 449 725
Any URLs contained in this publication were checked for currency during the
production process. Note, however, that the publisher cannot vouch for the
ongoing currency of URLs.
For permission to use material from this text or product, please email
aust.permissions@cengage.com
This 8th edition published in 2023
Australian Accounting Standards Board © Commonwealth of
National Library of Australia Cataloguing-in-Publication Data
Australia (2019) All legislation herein is reproduced by permission but does
ISBN: 9780170454797
not purport to be the official or authorised version. It is subject to
A catalogue record for this book is available from the National Library of
Commonwealth of Australia copyright. The Copyright Act 1968 permits certain
Australia.
reproduction and publication of Commonwealth legislation. In particular, s.182A
of the Act enables a complete copy to be made by or on behalf of a particular
Cengage Learning Australia
person. For reproduction or publication beyond that permitted by the Act,
Level 7, 80 Dorcas Street
permission should be sought in writing from the Commonwealth available from
South Melbourne, Victoria Australia 3205
the Australian Accounting Standards Board. Requests in the first instance should
be addressed to the Managing Director, Australian Accounting Standards Board,
Cengage Learning New Zealand
PO Box 204, Collins Street West, Melbourne, Victoria, 8007.
Unit 4B Rosedale Office Park
Association of Superannuation Funds of Australia Ltd, ACN 002 786 290,
331 Rosedale Road, Albany, North Shore 0632, NZ
Australian Council of Superannuation Investors, Australian Financial Markets
Association Limited ACN 119 827 904, Australian Institute of Company Directors
For learning solutions, visit cengage.com.au
ACN 008 484 197, Australian Institute of Superannuation Trustees ACN 123 284
275, Australasian Investor Relations Association Limited ACN 095 554 153,
1 2 3 4 5 6 7 26 25 24 23 22
Australian Shareholders’ Association Limited ACN 000 625 669, ASX Limited ABN
98 008 624 691 trading as Australian Securities Exchange, Business Council of
Australia ACN 008 483 216, , Chartered Accountants Australia and New Zealand,
CPA Australia Ltd ACN 008 392 452, Financial Services Institute of Australasia ACN
066 027 389, Group of 100 Inc, The Institute of Actuaries of Australia ACN 000 423
656, ABN 50 084 642 571,The Institute of Internal Auditors - Australia ACN 001
797 557, Financial Services Council ACN 080 744 163, Governance Institute of
Australia Ltd ACN 008 615 950, Law Council of Australia Limited ACN 005 260 622,
National Institute of Accountants ACN 004 130 643, Property Council of Australia
Limited ACN 008 474 422, Stockbrokers Association of Australia ACN 089 767 706.
All rights
reserved 2020.
g
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
BRIEF CONTENTS
1
Introduction to financial accounting ............................................ 1
2
The balance sheet and the income statement .......................... 40
APPENDIX TO CHAPTER 2: Background: sole traders,
partnerships, companies and financing ......................................76
3
Recording accounting transactions ............................................ 81
APPENDIX TO CHAPTER 3: Examples of how
debits and credits work ............................................................123
4
Accrual accounting adjustments .............................................. 132
5
Annual reports, regulation, internal control, ethics and
auditing ..................................................................................... 170
6
Financial statement analysis ..................................................... 203
7
Reporting and managing cash flows ....................................... 246
APPENDIX TO CHAPTER 7: Future cash flows:
present value analysis ...............................................................282
8
Extensions to financial reporting: assets, liabilities,
capital markets, contracts and accounting standards ............. 286
9
Sustainability reporting ............................................................. 313
10
Record-keeping ........................................................................ 337
11
Accounts receivable and further record-keeping .................... 389
12
Inventory ................................................................................... 447
13
Noncurrent assets ..................................................................... 473
14
Liabilities ................................................................................... 510
15
Equity, revenues and expense recognition ............................. 542
16
The statement of cash flows .................................................... 587
17
Measuring and managing organisational performance .......... 631
•
Get Complete eBook Download By email at student.support@hotmail.com v
Get Complete eBook Download By email at student.support@hotmail.com
CONTENTS
Guide to the text
xii
Guide to the online resources
xiv
Preface
xv
About the authors
xvii
Acknowledgements
xix
CHAPTER 1 Introduction to financial accounting
1
Chapter overview
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
1.13
Use and preparation of accounting
2
Financial accounting
2
Who uses financial accounting information?
3
The people involved in financial accounting
5
Accrual accounting
9
The key financial statements
12
Accounting principles and the use of accounting information
19
Framework for the preparation and presentation of financial statements
20
Qualitative characteristics of useful financial information
21
Financial statement concepts
23
Is accounting really important?
25
Financial management and the finance function
25
Do you really need a knowledge of accounting and financial management?
26
CHAPTER 2 The balance sheet and the income statement
40
Chapter overview
40
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
Introduction to the balance sheet
42
Explanations of the three balance sheet categories: assets, liabilities and equity
44
Some preliminary analysis of the Sound and Light balance sheet
47
A closer look at the balance sheet
50
Maintaining the accounting equation
53
Managers and the balance sheet
55
The income statement
55
Connecting balance sheets and income statements
59
A closer look at the income statement
61
•
vi Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Contents
2.10 Capital markets, managers and performance evaluation
APPENDIX TO CHAPTER 2: Background: sole traders, partnerships, companies
62
and financing
76
A2.1 Four kinds of business organisation
A2.2 Business financing
79
CHAPTER 3 Recording accounting transactions
81
Chapter overview
81
3.1
Transaction analysis
3.2
Transaction analysis extended
3.3
Recording transactions: double-entry bookkeeping
3.4
More about accounts
3.5
Debits and credits extended
3.6
Arranging accounts on the balance sheet
3.7
Journal entries
3.8
Cash versus accrual accounting revisited
APPENDIX TO CHAPTER 3: Examples of how debits and credits work
82
76
84
91
95
96
97
98
100
123
CHAPTER 4 Accrual accounting adjustments
132
Chapter overview
132
4.1
4.2
4.3
4.4
4.5
4.6
Financial accounting’s transactional filter
134
Conceptual foundation of accrual accounting
136
Accrual accounting adjustments
144
The financial period
151
Contra accounts
151
Managers and accrual accounting assumptions
153
CHAPTER 5 Annual reports, regulation, internal control,
ethics and auditing
170
Chapter overview
170
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
The annual report and financial statements
171
Accounting regulation in Australia
171
International financial reporting standards
174
Background to accounting policy choices
175
Internal control
178
Internal control of cash
182
Disclosure of internal control in annual reports
183
The nature of a profession and professional ethics
The external auditor’s report
Independence of the auditor
•
186
188
192
Get Complete eBook Download By email at student.support@hotmail.com vii
Get Complete eBook Download By email at student.support@hotmail.com
Contents
CHAPTER 6 Financial statement analysis
203
Chapter overview
203
6.1
6.2
6.3
6.4
6.5
6.6
6.7
Investment and relative return
204
Introduction to financial statement analysis
204
Common size statements
206
Financial statement ratio analysis
207
Financial statement ratio analysis example
214
‘What if’ effects on ratios
224
Measuring a manager’s performance
226
CHAPTER 7 Reporting and managing cash flows
246
Chapter overview
246
7.1
The purpose of cash flow analysis
7.2
Overview of the statement of cash flows
7.3
Interpreting a statement of cash flows (direct method)
7.4
Working capital management
7.5
Cash flow cycle
7.6
Cash flow forecasting
7.7
Cash budget
7.8
Capital investment analysis
7.9
Using Excel for NPV calculations
APPENDIX TO CHAPTER 7: Future cash flows: present value analysis
A7.1 Future cash flows
A7.2 Interest and the time value of money
247
248
253
255
256
258
258
260
266
282
282
282
CHAPTER 8 Extensions to financial reporting: assets,
liabilities, capital markets, contracts and
accounting standards
286
Chapter overview
286
8.1
8.2
8.3
8.4
8.5
Framework for the preparation and presentation of financial statements
288
Assets and liabilities: valuation and measurement
292
Capital markets
295
Contracts and financial accounting information
300
Managers and financial accounting standards
302
•
viii Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Contents
CHAPTER 9 Sustainability reporting
313
Chapter overview
313
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
What is sustainability reporting?
314
What information is reported in sustainability reports?
315
Do stakeholders require more than financial reporting?
317
Why do organisations produce sustainability reports?
319
Criteria for sustainability reporting
320
Alignment with Sustainable Development Goals
323
Trends in sustainability reporting
324
Integrated reporting
326
Consistency of sustainability reporting
331
CHAPTER 10 Record-keeping
337
Chapter overview
337
10.1
10.2
10.3
10.4
10.5
10.6
10.7
The importance of good records
338
Accounting’s ‘books’ and records
338
Illustrative example
352
Multi-column worksheets
359
Illustrative example
363
Electronic commerce
369
Managers, bookkeeping and control
370
CHAPTER 11 Accounts receivable and further record-keeping
389
Chapter overview
389
11.1 Receivables
11.2 Control accounts and contra accounts
11.3 Accounts receivable and contra accounts
11.4 Illustrative example
11.5 Trade discount and cash discount
11.6 Detailed recording using special journals, subsidiary ledgers and control accounts
11.7 Prime entry records: special journals
11.8 Subsidiary ledgers and control accounts
11.9 Operation of special journals and subsidiary ledgers
11.10 Role of general journal and general ledger
11.11 Bank reconciliations
11.12 Performing a bank reconciliation from information in cash journals
390
391
391
397
401
402
404
404
405
412
412
416
•
Get Complete eBook Download By email at student.support@hotmail.com ix
Get Complete eBook Download By email at student.support@hotmail.com
Contents
CHAPTER 12 Inventory
447
Chapter overview
447
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.8
12.9
Inventory control
448
Accounting entries for perpetual and periodic inventory
450
Inventory valuation and cost of goods sold
453
More about inventory cost flow assumptions
455
An example: Meeix Ltd
456
Lower of cost and net realisable value rule
460
Standard costs
462
Disclosure of inventory accounting policies
462
Managers and the valuation of inventory
462
CHAPTER 13 Noncurrent assets
473
Chapter overview
473
13.1 The cost of an asset: basic components
13.2 Depreciation of assets and depreciation expense
13.3 Depreciation bases and methods
13.4 Depreciation example
13.5 Gains and losses on noncurrent asset disposals
13.6 Asset revaluations
13.7 Asset impairment
13.8 Intangible assets
13.9 Goodwill
13.10 Finance leases
13.11 Managers and noncurrent assets
474
CHAPTER 14 Liabilities
510
Chapter overview
510
14.1 What is a liability?
14.2 General measurement principles
14.3 Financial statement presentation of liabilities
14.4 Payables
14.5 Interest-bearing liabilities: short term
14.6 Interest-bearing liabilities: long term
14.7 Tax liabilities
14.8 Provisions
14.9 Contingent liabilities
14.10 ’Off balance sheet’ financing
14.11 Goods and services tax
511
•
x Get Complete eBook Download By email at student.support@hotmail.com
475
478
484
485
486
488
490
492
493
494
512
513
514
515
517
518
519
521
523
524
Get Complete eBook Download By email at student.support@hotmail.com
Contents
CHAPTER 15 Equity, revenues and expense recognition
542
Chapter overview
542
15.1 Shareholders’ equity
15.2 Share capital
15.3 Reserves
15.4 Retained profits and dividends
15.5 Bonus issues and share splits
15.6 Revenues
15.7 Revenue recognition
15.8 The expenses concept: the Framework
15.9 Statement of profit or loss and other comprehensive income
15.10 Statement of changes in equity
15.11 ‘What if’ (effects) analysis
15.12 Managers, investments and shareholders’ equity and the recognition
544
of revenues and expenses
545
548
548
551
552
553
562
564
567
568
571
CHAPTER 16 The statement of cash flows
587
Chapter overview
587
16.1
16.2
16.3
16.4
16.5
16.6
Revision of the statement of cash flows
588
Preparation using the direct method
590
Interpreting a statement of cash flows using the direct method
600
Preparation using the indirect method
600
Interpreting a statement of cash flows using the indirect method
603
Cash flow and the manager
605
CHAPTER 17 Measuring and managing organisational performance 631
Chapter overview
631
17.1
17.2
17.3
17.4
17.5
17.6
17.7
17.8
What is performance management?
633
Integrative financial ratio analysis
633
Harvey Norman Holdings Limited: an example company
635
What about non-financial performance measures?
641
Key features of performance measures
643
The balanced scorecard framework
644
Performance management and an analytics mindset
649
Motivating managers and organisational performance
651
Glossary
659
Index
673
•
Get Complete eBook Download By email at student.support@hotmail.com xi
Get Complete eBook Download By email at student.support@hotmail.com
•
xii Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Guide to the text
•
Get Complete eBook Download By email at student.support@hotmail.com xiii
Get Complete eBook Download By email at student.support@hotmail.com
•
xiv Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
PREFACE
One question I have been frequently asked since writing the first edition of this book is: why write an
introductory accounting textbook?
First, I have been involved in teaching introductory financial accounting for over 35 years. I enjoy
trying to get across the introductory concepts. Second, I have been surprised at the differences
between how introductory accounting is taught in most undergraduate programs and how it is
taught in MBA courses in the United States and Australia. Thirty years ago there were good reasons
for the differences, as most of our first-year undergraduate students were accounting majors. This is
not the case today. Third, when I ask attendees at executive education programs what their
accounting background is, many respond that they did first-year accounting 10-plus years ago but
found it boring! We try to change this view by continuing to illustrate the importance of accounting
to the many roles our students will eventually take.
With this in mind, I tried to add to an undergraduate book some of the features that MBAs and
executives seem to enjoy. We don’t want our students returning in 10 years and suggesting our
courses are boring! Talking about companies and relating the material to annual reports helps
students to get interested.
With all of the above in mind, we set about incorporating the following in the book. First, we
have tried to make clear to students the importance of accounting information by frequent
reference to current material. Second, as companies are the most common business organisations
in Australia today, we start by writing about companies, rather than spending many introductory
chapters concentrating on sole traders. Third, to keep this book’s material interesting and relevant,
we have made frequent references to the content of annual reports. Students learn about real
companies and can follow their performance in the newspapers or the share market if they wish.
Fourth, we believe that the depth of technical knowledge in this book will challenge both
accounting and non-accounting majors, but lecturers can choose to leave some sections to more
advanced courses.
The first edition of this textbook was adapted from the second edition of the best-selling
Canadian introductory financial accounting textbook of the same name written by Michael Gibbins.
In the Australian edition, we added eight chapters as well as reorienting the material towards the
Australian context.
The most attractive features of the early editions have been retained: an easy-to-read style with a
wealth of extracts from company annual reports, ‘How’s your understanding?’ activity questions
throughout each chapter, questions at the end of each chapter relating to real annual reports, as
well as a set of cases with questions relating to the Woolworths Limited Annual Report 2021
(appendix at the end of the book).
My co-authors for the seventh edition were Elizabeth Carson and Kate Morgan. Kate has
remained on as an author of the eighth edition, while Elizabeth has now retired from academia after
an illustrious research and teaching career. She made numerous improvements to earlier editions
and students will still benefit from her insights. For the eighth edition, Professor Kerry Humphreys
and Dr Victoria Clout have joined the author team. Kerry and Victoria have both won very important
education awards as you will see from their biographies.
•
Get Complete eBook Download By email at student.support@hotmail.com xv
Get Complete eBook Download By email at student.support@hotmail.com
Preface
The eighth edition of the textbook has involved some major reconstructions. It has added a
range of material on financial management, sustainability reporting and performance evaluation.
The revised title is Fundamentals of Accounting and Financial Management. It has 17 chapters
which we believe gives instructors the opportunity to choose whether to do it over two subjects or
to choose the chapters they need for one subject (the publisher can arrange for the selection of
chapters).
The combination of chapters of the book are used in many different combinations. Examples
include:
Undergraduate first year accounting: the introductory financial accounting/financial management
subject uses chapters 1–9 and the follow-up accounting subject for accounting majors uses chapters
10–17. The advantage of this is that all majors cover the basics of accounting including financial
statement analysis and cash flows. The second subject then serves as the basics for accounting
majors including the accounting process through to a more advanced treatment of cash flow
statements.
Master of professional accounting courses: can use chapters 1–4, 10–15, 6–7 and then 16–17. This
allows all of the financial analysis and cash flow material to be completed together.
Core MBA financial accounting subject: covers chapters 1–9 with an option to exclude parts of
Chapter 3 (from 3.3 onwards). It would also cover Chapter 17.
All the authors are very happy to discuss these options with an instructor that would like to
innovate with any of these chapters.
We trust that you will enjoy the book.
Ken Trotman
•
xvi Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
ABOUT THE AUTHORS
Ken Trotman is Scientia Professor in the School of Accounting, Auditing and Taxation at UNSW
Sydney. He is a Fellow of both CPA Australia and Chartered Accountants Australia and New
Zealand. Ken’s major research interests include examining the processing of information by users of
accounting reports and auditors, and the factors that affect the quality of their decisions. He has
received a number of major awards from the American Accounting Association including
Outstanding Educator Award by the Audit Section, the Notable Contribution to the Auditing
Literature Award, and Notable (Lifetime) Contribution Award in Behavioral Accounting Literature. He
is a life member and former president of the AFAANZ and Director of Research for the audit section
of the American Accounting Association. He has over 35 years of university teaching experience. In
addition to teaching at UNSW, he has taught MBAs at the University of Illinois at Urbana –
Champaign, Cornell University and the University of Michigan. He has extensive consulting
experience and has conducted many executive training programs in both the private and public
sectors. He has published widely in Australian and international research journals and was inducted
into the Australian Accounting Hall of Fame in 2011. In the Australia Day 2020 Honours he was
appointed Member of the Order of Australia (AM) for significant service to education, particularly to
accounting.
Kerry Humphreys is a Professor in the School of Accounting, Auditing and Taxation at UNSW
Sydney. Kerry’s research investigates when managers make effective decisions incorporating
strategic, financial and non-financial performance information, and how new managers and
accounting professionals can learn to make better decisions using this information. Her research is
internationally awarded by the American Accounting Association, Accounting, Behavior and
Organizations section. In the classroom, Kerry aims to empower postgraduate business students to
become effective decision-makers by developing and delivering a strategy+numbers approach, and
works with managers and executives to enhance their accounting and financial management skills in
order to make critical business decisions. She is a multi-award winning educator for curricula
development and teaching delivery, including an Australian Learning and Teaching Council Citation
for Outstanding Contributions to Student Learning, Pearson Education Accounting & Finance
Lecturer of the Year award and dual Vice-Chancellor’s Awards for Teaching Excellence. Kerry is a
qualified Chartered Accountant (FCA) and prior to completing her PhD, worked with
PricewaterhouseCoopers and IBM Global Business Services.
Victoria Clout is a Senior Lecturer and Deputy Head of School (Education) in the School of
Accounting, Auditing and Taxation at UNSW Sydney. Her research area is the corporate disclosure
environment and corporate governance. Victoria’s research has been published in various journals
and has relevance to market regulators, financial statement preparers and investors. She was a
Co-Guest Editor of an Accounting Research Journal Special Issue on the topic of innovations during
the pivot to teaching online in the COVID-19 period. Victoria has received several teaching awards
•
Get Complete eBook Download By email at student.support@hotmail.com xvii
Get
eBook Download By email at student.support@hotmail.com
About
theComplete
Authors
including a 2020 UNSW Higher Education Heroes award. Prior to joining UNSW in 2011, her previous
positions were at the University of Queensland and University of Western Australia. She is an
Associate Editor of Accounting & Finance journal and an Honorary Fellow of the Hanken Centre for
Accounting, Finance and Governance.
Kate Morgan is a sessional lecturer in the School of Accounting, Auditing and Taxation at UNSW
Sydney, teaching the core financial accounting subject in the Master of Professional Accounting
Program and both the full-time and executive AGSM MBA Programs. She holds degrees from
UNSW in both accounting and education, including graduating with Excellence in the Master of
Education (Higher Education). She has designed accounting materials for undergraduate and
masters programs in both face-to-face and online settings. Kate has published research in
accounting education and has received teaching awards including the UNSW 2020 Business School
Commendation Award for Teaching Excellence by Adjunct/Sessional Faculty. Prior to returning to
the university, she held senior management positions specialising in project and program
management, accounting and information systems design.
•
xviiiGet Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
ACKNOWLEDGEMENTS
The completion of this book was only achieved with the help of many individuals. My greatest thanks
go to my former colleague, the late Gordon Howitt. Over 40 years ago Gordon inspired my interest
in accounting. He taught me first-year accounting and subsequently as a staff member provided me
with guidance and support. Without his help I could not have written this book. During the first
edition he encouraged me, regularly checked on progress, continually read drafts, provided many
questions, authored the solutions manual and generally offered friendship and support. This
support continued with the reviewing of the second edition. For 50 years he made an outstanding
contribution to accounting education at UNSW. I certainly have never met a more dedicated
accounting teacher. It has been a privilege to work with him and we all miss his inspiration.
My original co-author Mike Gibbins was kind enough to invite me to adapt his original Canadian
textbook. Mike has an outstanding reputation as a researcher, and I liked his version of the book so
much that I decided to take on the task of co-author. Mike has now retired after a very distinguished
career as one of the world’s leading accounting researchers and a truly outstanding teacher.
Professor Elizabeth Carson took over as co-author, has provided me with many helpful suggestions
on previous editions of the book and has helped to reshape many parts of the latest editions of the
book. Our new co-author for the seventh edition, Kate Morgan, has contributed to the book across
numerous editions and now takes on a more extensive role.
My life has been made much easier with the help of some very capable research assistants. Staff
at UNSW and some other universities have been generous in providing me with material. Michael
Pennisi provided material on GST and material on subsidiary ledgers, now in Chapter 8. Athol
Carrington and Gordon Howitt provided me with some material in Chapter 5, as well as numerous
questions, and Malcolm Miller with some material in Chapter 7. Rosina Mladenovic provided some
material for Chapters 9 and 10 as well as numerous comments on the book. Gerry Galley wrote
substantial sections of Chapter 11. Noel Harding provided material for Chapter 7. Chapter 17 was
largely written by Andrew Trotman with excellent inputs from Tanya Fiedler, Sarah Adams and Hien
Hoang as well as advice from Roger Simnett and Patricia Strong. Questions were also provided by
Kevin Clarke, Victoria Clout, Claudia Gormily, Dean Hanlon, Noel Harding, Cameron Hooper,
Andrew Jackson, Helen Kang, Jeffrey Knapp, Chris Poullaos, Patricia Strong and Per Tronnes. Other
useful comments were provided by present and ex-UNSW staff including Nicole Ang, Kar Ming
Chong, Conor Clune, Robert Czernkowski, Neil Fargher, Roger Gibson, Wendy Green, Noel
Harding, Andrew Jackson, Amna Khalifa, Janice Loftus, Diane Mayorga, Malcolm Miller, Richard
Petty, Baljit Sidhu and Roger Simnett. Over various editions, advice from Stephen Bah (University of
Newcastle), Peter Carey (Monash University), Peter Collett (University of Tasmania), Russell Craig,
Linda English (University of Sydney), Vic Fatseas (Charles Sturt University), Jack Flanagan, Dean
Hanlon (Monash University), Jan Hollingdale (Bond University) and Greg Whittred was appreciated.
Cengage also arranged for use of some material in Chapter 6 from the US book by I. Solomon,
L. Wither, P. Vargo and L. Plunkett. A special thanks to Judith Quinn for extensive word processing
of the materials.
Ken Trotman
•
Get Complete eBook Download By email at student.support@hotmail.com xix
Get Complete eBook Download By email at student.support@hotmail.com
Acknowledgements
Cengage would also like to thank the following reviewers, who provided helpful and useful
comments while this edition was being developed:
Debbie Wills, University of Tasmania
Christine Contessotto, Deakin University
Dr. Munshi Samaduzzaman, Central Queensland University
Jinhua Chen, Macquarie University
Maria Tyler, Central Queensland University
Hajar Roudaki, University of Wollongong
Pattarin Adithipyangkul, Curtin University.
Every effort has been made to trace and acknowledge copyright. However, if any infringement has
occurred, the publishers tender their apologies and invite the copyright holders to contact them.
•
xx Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
Introduction to
financial accounting
1
ON COMPLETION OF THIS CHAPTER, YOU SHOULD BE ABLE TO:
LO1
describe the basic purpose of financial accounting (1.1, 1.2)
LO2
identify the users of accounting information and the decisions they make that require accounting information
(1.3)
LO3
LO4
LO5
LO6
LO7
LO8
LO9
LO10
identify the people who are involved in financial accounting (1.4)
describe how accrual accounting differs from cash accounting (1.5)
explain the basic contents of the three key financial statements and describe the purpose of each statement (1.6)
explain why accounting needs standards and principles, including the role of GAAP (1.7)
describe the objective of financial reports (1.8)
describe the basic principles of accounting (1.9, 1.10)
outline the qualitative characteristics of useful financial information and key concepts (1.9, 1.10)
explain why accounting and financial management are important (1.11, 1.12, 1.13).
CHAPTER OVERVIEW
Accounting has been described as the ‘language of business’. It provides managers within organisations and
those outside the organisation (e.g. investors and creditors) with information about the financial performance
and financial position of the business. Regardless of what type of career you pursue, accounting information
will have important effects on you.
This chapter introduces you to financial accounting and illustrates some useful accounting concepts and
techniques. It outlines a way of thinking about financial accounting that will be important to your career,
whether you become an accountant or a user of accounting in business or in other walks of life. We believe
that every manager is a user of accounting information but some managers use accounting information
better than others. You are introduced to the social setting of financial accounting and some of the people
involved. Financial accounting is complex and requires sound judgement because it attempts to serve the
needs of all these people, not all of whom necessarily see things the same way. You are then introduced to
one of the cornerstones of how financial accounting works: accrual accounting, the broad framework within
which financial accounting reports are prepared. You are also introduced to the three key financial
statements and the basic financial statement assumptions.
Get Complete eBook Download By email at student.support@hotmail.com
1
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
1.1 Use and preparation of accounting
LO1 Financial accounting has value because the information it produces is used in a variety of ways. Users include
managers, investors, bankers, financial analysts and many others. Such people study accounting to learn how
to use information effectively and to do their jobs better. For accountants, this information is essential to the
services they provide.
Accounting is a complex human activity. Accounting information doesn’t just happen: it is produced by a
large set of people, activities and computers. To be effective users of the information, people need to know
something about how and why the information is prepared. Accountants’ expertise is all about the how and
the why.
The demand for useful information shapes how financial accounting information is prepared; for example,
when producing annual or monthly performance reports. How it is prepared shapes its use; for example, in
analysis of financial statements and managerial decisions using accounting information.
HOW’S YOUR UNDERSTANDING?
Learning terminology is important. To help you with that, this book has a glossary of terms at the back. If you’re not sure
what a term means, look it up right away.
Accounting is a challenging discipline that involves many capabilities: assigning numbers to represent financial
phenomena; providing explanations of those numbers; analysing and verifying the information prepared by others,
understanding the needs of those who use accounting’s reports to make decisions, communicating with the many
people involved in an organisation’s financial activities and maintaining judgement that is sound, objective and ethical.
Much of the challenge of accounting is in figuring out which numbers to use and deciding what the numbers tell us.
Adding and subtracting the numbers is often the easy part. This makes accounting both easier and harder to learn than
you might have thought. Accounting is rooted in the financial setting, and has its own vocabulary, so don’t expect it all to
make perfect sense at the beginning. It will take a while for you to acquire the knowledge that creates an understanding
of business and accounting as they really are in our world. This understanding will be based on your knowledge of both
concepts and techniques, and of the viewpoints of both accountants and the users of accounting.
The going will not all be easy, but if you give it your best effort, you may be surprised at the high level of
sophistication you will reach. Here is one important suggestion. The only way to learn accounting is to do problems. It
is vital that you do more than just read the examples. After reading the chapter, come back and do the examples to
check your understanding. Throughout the book there are many questions called ‘How’s your understanding?’. Try to do
the question and then look up the answer at the end of the chapter. These questions are numbered 1A, 1B, 1C, etc.
where 1 indicates the chapter and the letter indicates the particular question.
1.2 Financial accounting
LO1 Accounting is a process of identifying, measuring and communicating economic information to allow
informed decisions by the users of that information. Accounting systems are often described as either
financial accounting systems (where periodic financial statements are provided to external decision-makers,
such as investors, creditors and customers) or management accounting systems (including information for
planning and performance reports to managers throughout the organisation; that is, internal decision-makers).
Financial accounting measures an organisation’s performance over time and its position (status) at a point
in time, and does so in Australian dollars, US dollars, yen, euros or whatever currency is judged relevant to
the organisation. This measurement of financial performance and financial position is done for all sorts of
organisations: large and small businesses, governments from local to national levels, universities, charities,
churches, clubs, international associations and many others. The financial statements, which are financial
2
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
accounting’s reports, summarise the measurements of financial performance and financial position in standard
ways thought to be useful in evaluating whether the organisation has done well and is in good shape. These
financial statements include notes, which contain many words (sometimes dozens of pages) of explanation
and interpretation, in addition to the numbers. The statements report on the economic and financial matters
and are largely for the use of people outside the organisation, such as investors, lenders, club members,
regulatory agencies and taxation authorities.
In summary:
• Financial performance is the generation of new resources from day-to-day operations over a period of
time.
•
Financial position is the organisation’s set of financial resources and obligations at a point in time.
•
Financial statements are the reports describing financial performance and financial position (e.g. the
balance sheet and the income statement).
•
Notes are part of the statements, adding explanations to the numbers.
As we will see throughout this book, financial performance and position are highly related. Good
performance is likely to lead to a healthy financial position; if a company has been making profits, it will
probably build up resources. On the other hand, a healthy financial position facilitates performance; if you
have lots of resources compared to obligations, the company can undertake activities that lead to good
performance.
Another branch of accounting, management accounting, is oriented towards helping managers and others
inside the organisation, in contrast to financial accounting’s more external focus. While management
accounting is not examined in this book, students interested in how financial accounting measures
managerial performance will find frequent references to the relationship between managers and financial
accounting. In the end, all forms of accounting exist to help people such as managers, investors, bankers,
legislators and the public make financial decisions.
HOW’S YOUR UNDERSTANDING?
1A What are the two main things that financial accounting measures?
[Answers to all ‘How’s your understanding?’ questions are at the end of each chapter. Make sure you try to answer
the question prior to looking up the answer.]
1.3 Who uses financial accounting information?
This book will show you the many ways in which financial accounting has been shaped by the development
of business and society. Financial accounting helps:
• stock market investors decide whether to buy, sell or hold shares of companies
•
banks and other lenders decide whether or not to lend
•
managers run organisations on behalf of owners, members or citizens (in addition to the help provided by
management accounting and other sources of information)
•
management by providing basic financial records for the purposes of day-to-day management, control,
insurance and fraud prevention
•
governments in monitoring the actions of organisations and in assessing taxes, such as income tax and
the goods and services tax (GST)
•
managers are often rewarded in the form of bonuses based on profit performances.
Whole books can be, and have been, written about each of these functions. Though this book emphasises
externally oriented financial accounting for business firms, don’t forget that there are many other
Get Complete eBook Download By email at student.support@hotmail.com
3
LO2
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
organisations that use, and are affected by, accounting (government departments, not-for-profit organisations
including charities, sporting and cultural organisations). When words like ‘organisation’ or ‘company’ are used,
the implications often go well beyond business firms.
The centre of our interest in this book – financial accounting for the organisation – operates within and
serves a complex social setting. It seeks to monitor and report on financial events initiated by or happening to
the organisation. While accounting tells us what is going on, in so doing it affects our decisions and actions
and, therefore, also affects what is going on. For example, accounting information may determine whether an
organisation hires more staff or reduces staff numbers. It will also likely affect the amount spent on contractors.
The social setting is composed of many people, including groups, companies, institutions and other
parties interested in, or having an influence on, the company’s financial accounting. As we will see many
times in this book, these parties do not share the same interest in the company’s accounting, and may even
be in competition or conflict with each other. For example, management are likely to prefer higher salaries
but this may or may not be in the best interest of shareholders. Most will be in the same country as the
company and its management but, increasingly, companies and other organisations are operating
internationally. The other groups interested in, and affecting, the company’s financial accounting may be
located across the globe.
Let’s consider some possible users of the financial statements of a listed company:
• A company’s board of directors manages the company on behalf of its shareholders. One function of the
board, which involves the financial statements, is hiring the company’s top operating management –
especially the chief executive officer (CEO). Suppose you are a member of the board and are preparing
for a discussion at the next board meeting. The board evaluates the CEO’s performance continuously,
which is its responsibility. The financial statements have been provided to the board prior to the meeting,
and will be a major contribution to this evaluation.
•
A company’s shares are listed (i.e. can be bought and sold) on the Australian Securities Exchange (ASX).
Suppose you are a financial analyst for an investment banker and are preparing a report projecting future
earnings and making recommendations about whether the company’s shares are worth buying, keeping if
already held, or instead should be sold. You have the financial statements and will use them to support
your report.
•
A company has several hundred million dollars in bank borrowings, and lines of credit (pre-authorised
borrowing capability) for millions of dollars more. Suppose you are a commercial lending officer for a
bank, conducting a regular review of the company’s borrowing status. You must consider the quality of
the company’s financial performance and assets (many of which have been assigned as security on bank
loans, and therefore could be seized if the company doesn’t pay its loans back on schedule). Financial
performance is important because net profit generates cash to pay loans, and a good past record
suggests that the company is likely to be able to earn profit in the future. You have requested the
financial statements to use in your review.
•
A company depends on a large number of suppliers to obtain goods and services. Suppose you are the
sales manager of a stationery supplier and are considering signing a long-term contract to supply the
company. You want to sign the contract because your company needs the business, but you have to be
satisfied that your shipments will be paid for. More positively, you hope that if you do a good job, you
will have an opportunity to grow with the company. Most of the information you need has been received
already, but you have obtained the financial statements and are reviewing them as you make your final
decisions about the contract.
•
Management and unions often negotiate about an increase in pay rates for workers. One key input is the
ability of the company to pay these increases. A company’s financial statements are an important input to
this decision.
•
In summary, these scenarios indicate the following reasons for using the company’s financial statements:
evaluation of the CEO’s performance by a member of the board of directors
•
preparation of ‘buy’, ‘sell’ or ‘hold’ recommendations by a financial analyst
4
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
•
review of the company’s borrowing status by a bank lending officer
•
development of a supply contract with the company by a stationery supplier’s sales manager
•
determining pay rises by management and unions.
These scenarios have been chosen to add to your insight into the use of financial accounting information.
They are not complete. In all cases, the financial statements would be only part of the information used in the
decision-making process. Also, there are many other uses for financial statements, some of which might make
different demands on the quality of the information from those discussed here.
FOR YOUR INTEREST
In the previous text, we noted that financial statements would be only part of the information used by various groups such
as investors and management in decision-making. Another important type of information is sustainability reporting. These
reports include information on economic, environmental, social and safety performance. For example, they could include
information on carbon emissions, energy usage, employee safety, community involvement, etc. We introduce this material
in Chapter 9, as many companies now include this information in their annual reports or in separate sustainability reports.
1.4 The people involved in financial accounting
LO3
The main participants in the art of financial accounting are:
• the information users (the decision-makers)
•
the information preparers, who put together the information to facilitate the users’ decision-making
•
the auditors, who assist the users by enhancing the credibility of the information, providing a professional
opinion about the fairness and appropriateness of the information.
Users (decision-makers)
In financial accounting, a user or decision-maker is someone who makes decisions on the basis of the financial
statements, on his or her own behalf, or on behalf of a company, bank or other organisation. Ultimately, the
nature and contents of financial statements are functions of the demand for decision information from users. If
user demand is the fundamental reason for financial statements, understanding the demand is important.
A user’s main demand is for the credible periodic reporting of an organisation’s financial position and
performance:
• Credible means that the information in the reports (the financial statements) appears to be sufficiently
trustworthy and competently prepared for it to be used to make decisions. There is a cost–benefit issue
here: huge amounts of money could be spent trying to make the reports absolutely perfect, but since
that money would have to come out of the organisation’s funds, spending it would make its performance
and position poorer. Users, such as owners and managers, may not want that to happen, so credibility is a
relative condition, not an absolute one. Accounting information has to be worth its cost.
•
•
Periodic means that users can expect reports on some regular basis (such as yearly or quarterly). The
longer the wait, the more solid is the information. But waiting a long time for information is not
desirable: users are willing to accept some imprecision in the information in return for periodic reports
with timely, decision-relevant information.
The main groups of users are as follows:
Owners are individual business owners, such as proprietors, partners and other entrepreneurs; individual
investors (shareholders) in shares on stock markets who can vote on company affairs; companies that
invest in other companies; superannuation funds and other institutions that invest in companies; and
people with quasi-ownership interests, such as members of recreation and sporting clubs or voters in
Get Complete eBook Download By email at student.support@hotmail.com
5
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
local councils. In respect of companies, shareholders own portions of the corporation – shares that can be
bought and sold – but the corporation is a legal entity existing separately from its shareholder owners.
Investors purchase shares in a company with the hope of gaining in two ways: receiving a portion of the
company’s profit in the form of dividends, and being able to sell their shares in the future at a price
higher than they paid.
•
Potential owners are people of the same sort as the owners listed previously, who do not at present have
funds invested in the organisation but may be considering making such an investment. Because potential
owners often buy shares from present owners – for example, by trading shares on the stock market –
rather than investing directly, there is often a significant difference in outlook between present owners,
who may wish to sell their shares for as much as possible, and potential owners, who would like to pay as
little as possible.
•
Creditors and potential creditors are suppliers, banks, bondholders, and others who have lent money to
the organisation, who are owed funds in return for supplying something of value, or who are considering
taking on such a role. Creditors do not have the legal control of the organisation that owners have, but
they often have a large say in organisation decisions, especially if the organisation gets into financial
difficulty. In cases of extreme difficulty, creditors may have the right to take over control of the organisation
from the owners. Creditors need to decide whether to supply goods or services to the firm on credit.
•
Managers are those who run the organisation on behalf of the owners. They have a great interest in the
way accounting reports on their activities and results. They use the information for planning, controlling
and organising the activities of the entity. Often managers’ salaries and bonuses, and the likelihood of
staying in their jobs, are directly affected by the contents of the financial statements. In small businesses
in particular, the owner may also be the main manager.
•
Employees and their unions or other associations are interested in the organisation’s ability to pay wages,
maintain employment levels and keep such promises as paying superannuation contributions. Financial
information can be used to assess job security.
•
Regulators and other government bodies and agencies are groups that may use the financial statements
as a basis to evaluate whether the organisation is following various rules and agreements.
•
Financial and market analysts are people who study companies’ performances and prepare reports for
others by analysing those companies. Analysts often make recommendations about whether to invest,
sell shares or do neither.
•
Competitors may use the financial statements to try to understand the organisation’s operations for the
purpose of better understanding what their competitors will do in the future and, therefore, what
decisions they should make. Sometimes, for example, managers are reluctant to disclose information to
shareholders, because competitors can then also obtain it and act to reduce the organisation’s prospects.
For example, large retailers may disclose profit by state but it is unlikely they will do this for each store
location, as competitors may use this information to decide what locations are most profitable and set up
competitive stores in those areas.
•
Accounting researchers are people – mostly university academics, but also some based in accounting
firms and other organisations – who study accounting with the objective of understanding it and
contributing to its improvement.
•
Customers need to consider if the entity is financially sound. This is particularly important when customers
are required to pay amounts in advance, such as on a building contract. It is also important if customers
rely on the warranties for repairs provided by the entity.
•
Miscellaneous third parties are various other people who may get access to an organisation’s financial
statements and use them in various ways. Once statements have been issued, many people may make
use of them. For example, politicians may make judgements about industry efficiency or taxation levels,
journalists may write stories about employment practices, and judges may evaluate the organisation’s
ability to pay if it loses a lawsuit.
6
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
Think about all these users and decisions! It is a great challenge to develop one set of periodic financial
statements for an organisation so that it can be useful for all. Perhaps you will not be surprised to know that
there is much controversy about whether financial statements do this well, and whether financial accounting
methods serve some users or decisions better than others.
How likely is it that you, the reader, will use accounting information in the future?
If you plan to be an accountant, the value of studying financial accounting is clear. It may not be so clear,
however, if you have other plans, such as a career in management, marketing, engineering, law, human
resources or production. To provide some perspective to those of you not planning an accounting career,
and to help you understand the managers you will work with if you do become an accountant or auditor,
comments will be made frequently about managers and financial accounting.
Financial accounting is directly relevant to managers because it reports on the managers’ performance
as decision-makers, caretakers of the organisation, representatives of the owners, legal officers of the
organisation, and so on. Any manager cannot help but be interested in how her or his performance is being
measured and in how that performance is analysed, projected and otherwise evaluated. Managers’ bonuses,
promotions, dismissals, transfers and other rewards and penalties are often directly based on the numbers
prepared by accountants. Every manager should have an intimate understanding of how accounting is
measuring his or her performance and should be able to conduct a ‘reasonableness check’ of the
information being provided. It is critical for managers to understand the impact of every decision they are
making on accounting numbers as these numbers will measure their performance.
Here are a few examples of how non-accounting managers may use accounting information:
• Marketing managers need to understand the financial statements of potential customers to determine
which customers to focus on and which ones to extend credit to. They also need to know the profitability
of individual products.
•
Purchasing managers need to understand suppliers’ financial statements to make sure they have the
capacity to supply in the long term.
•
Human resources managers use accounting information in salary negotiations.
•
Information systems designers need to include the accounting information system in their design.
If you are extremely talented and have decided to make your fortune as a sports star or musician, you still
need to know about accounting. We suggest that understanding the financial statements of the Sydney
Cricket Ground or the Opera House would be of benefit in negotiating with those organisations.
FOR YOUR INTEREST
Over the last few years there have been major negotiations between football (various codes) and cricket players and
administrators over how total revenues of the sports should be shared between players and other stakeholders. That is,
the players, their representatives and the administrators are using the information in the financial statements of the
sporting bodies as part of the negotiations over salaries and other benefits.
Preparers (decision facilitators)
Two main groups are responsible for the information in the financial statements:
• Managers are responsible for running an organisation, including issuing accounting and other information,
and controlling its financial affairs. The fact that managers are also users, and are vitally interested in the
results, has created a fundamental conflict of interest for them and has led to the development of the
auditing function (see the next section). Managers are often referred to, as a group, as management.
•
Accountants, who are part of the senior management team, have the job of shaping the financial
statements by applying the principles of accounting to the organisation’s records, under the direction of
management. Many accountants are members of professional bodies, such as CPA Australia and Chartered
Get Complete eBook Download By email at student.support@hotmail.com
7
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
Accountants Australia and New Zealand. Accountants and their professional bodies also often have auditing
experience and interests, and sometimes auditing roles, but the task of preparing the financial statements is
quite different in principle from the task of verifying those statements once they are prepared.
Auditors (credibility enhancers)
Auditors report on the credibility of the organisation’s financial statements, on behalf of owners and others.
Auditors have the job of assisting the users by verifying that the financial statements have been prepared fairly,
competently and in a manner consistent with accepted accounting principles. The auditing role is a very old
one, arising because users demanded some assurance that managers’ reports on their performance were not
self-serving or biased. This book refers frequently to external auditors, who report on the financial statements
on behalf of external users, but there are also internal auditors, who work within the organisation to support
the credibility of information being used by management. External auditors provide an opinion on the truth
and fairness of the financial statements. While external auditors may be asked for advice in preparing the
statements, especially for small companies, they must avoid responsibility for the statements because their
role is to scrutinise the preparation process. They cannot credibly audit statements they have prepared!
The external auditors are formally appointed by the owners; for example, at the annual shareholders’
meeting. But an organisation’s external auditor is not permitted to be an owner or manager of the
organisation. For example, they cannot own shares in the company and they cannot act as a director or
manager of the company, even for a small part of the year. This is to ensure that the auditor is financially and
ethically independent and can therefore be objective about the organisation’s financial affairs. Independence
and objectivity are fundamental ideas that you will encounter frequently in this book.
External auditors may work alone or in partnership with other auditors in accounting firms. Some of these
firms are very large, having thousands of partners and tens of thousands of employees, and offices in many
cities and countries. Accounting firms offer their clients not only external auditing but also advice on income
tax, accounting, computer systems and many other financial and business topics. However, if they conduct
the audit there are rules in place about what other services they can provide, as auditors cannot be involved
in auditing their own work, or creating any conflict-of-interest problems. Managing this requires considerable
professional skill and attention to the ethics and rules of professional conduct. Whether this is being done
successfully is a matter of much controversy at present. In Australia, as well as in many overseas countries,
there has been additional regulation aimed at improving the independence of auditors. The large accounting
firms annually spend many millions of dollars on their independence and quality-control systems. In 2020 a
parliamentary committee inquiry released the Regulation of Auditing in Australia report, with a range of
recommendations to improve audit quality.
People and ethics
Ethics, mentioned previously, will be raised throughout this book. Ethical issues can arise in just about any
area of accounting. Here are some examples, all of them real:
• An organisation has been sued by a recently fired employee who claims that the dismissal was based on
the employee’s age, and therefore broke employment laws. The organisation’s general manager denies
any impropriety. The organisation’s chief accountant, who personally feels that the former employee’s
claim is justified, has suggested to the boss that the lawsuit should be mentioned in a note to the
financial statements, so that users of the statements will know there is a potential for loss if the former
employee wins. The general manager feels that the chief accountant should ignore the lawsuit in
preparing the financial statements, to avoid embarrassment and the appearance of admitting guilt. The
general manager fears that such an apparent admission could be used against the organisation in court
and so could cause the organisation to lose the lawsuit. What should the chief accountant do?
•
8
While doing an audit, the external auditor learns that the organisation may have been cheating one of its
customers. The customer, who is unaware of this and quite happy with things, is another client of the
auditor. The auditor, who is bound by rules of conduct designed to protect the confidentiality of
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
information gained during the audit, knows that saying anything to anyone could result in major lawsuits.
Should the auditor just keep quiet about what was found?
•
A third organisation’s senior managers are paid a bonus each year, calculated as a percentage of profit.
Management is considering a proposed change of accounting methods that will reduce expenses this
year and therefore raise accrual profit and increase bonuses. Should senior management refuse to
implement the accounting change, request that the bonus calculation ignore the change, or just go
ahead and enjoy the higher bonus?
These illustrative problems do not have easy answers, so none are offered here. They are dilemmas for the
chief accountant, the auditor and the general manager. This book will address ethical issues from time to time,
helping you to sharpen your ethical sense along with your accounting knowledge – the two are inseparable.
1.5 Accrual accounting
Financial accounting’s task of producing financial statements is a complex one. For even a small business,
thousands of events (transactions) have to be recorded and their financial effects evaluated. For large
corporations such as BHP, Lend Lease, Rio Tinto, Woolworths, AMP, Qantas and Westpac, or organisations such
as the University of New South Wales, Brisbane City Council or the Red Cross, the number of annual
transactions runs into the millions or billions. Frequently, when the time comes to prepare the financial
statements, some transactions have not been completed, are in dispute or have an otherwise unclear status.
To cope with these complexities, financial accounting for most businesses and organisations uses the
accrual accounting approach. Under an accrual accounting system, the impact of transactions on the financial
statements is recognised in the time periods during which revenues and expenses occur, rather than when
the cash is received or paid. Formal definitions of revenues and expenses can be quite complicated, and are
left to Chapter 2. At this stage, we will provide examples of the main types of revenues and expenses.
The main form of revenue is usually the sale of goods or services; for example, the sale of machines for
$45 000 each, carrying out the installation of a new computer system for $300 000 or providing consulting
advice for $40 000. For Woolworths, the sales could be a trolley of groceries. Other revenues include interest
on investments held, dividends received on shares and rent from premises owned by the company.
Consider the main revenues and expenses for a coffee cart you see on campus or in the city. The main
revenue will come from coffee sales. If all sales are cash sales it would be the cash received for the coffees
sold. But note most customers use their credit card (where it may be days/weeks before the cash is received)
or that some customers may have an account where all coffees sold to them are recorded and then they pay
the whole amount the following month on receipt of an invoice. Note that under accrual accounting it is the
delivery of the service (i.e. handing over the cup of coffee) that results in revenue being recognised.
Expenses include the costs of services and resources consumed in the process of generating revenues.
Examples of costs incurred are wages, electricity, travel and rent. An example of resources consumed is
depreciation. Organisations depreciate the cost of an asset (such as a motor vehicle or a printing machine)
over the useful life of the asset; that is, each year a percentage of the cost of the asset becomes an
expense. These assets are helping in generating revenue; therefore, a share of the cost should be treated as
an expense in each accounting period during which the asset helps generate revenue.
Why do we depreciate the cost of an asset over its useful life rather than treat the cost of the asset as an
expense in the first year? The reason is that the asset is used over many years and helps generate revenue
over many periods. This depreciation expense is matched to the revenues earned during the period. Note
that estimates need to be made. For example, a printing machine that cost $480 000 would have annual
depreciation of $120 000, $96 000 or $80 000, depending on whether its estimated life is four, five or six
years; that is, the judgement on the useful life of the machine has an impact on profit each year.
Now consider the main expenses of the coffee cart mentioned previously. Likely expenses include:
• the cost of coffee
•
the cost of cups
Get Complete eBook Download By email at student.support@hotmail.com
9
LO4
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
•
wages
•
rent of space (e.g. to the university)
•
depreciation on the coffee machine
•
insurance.
Accrual accounting versus cash accounting
Before considering these complexities, let’s consider the basic differences between cash accounting and
accrual accounting.
• Cash accounting involves recording revenues and expenses at the time the cash is received or paid. This
is reasonably precise, because the accountant knows whether cash has been paid or received and the
exact amount is easily determined (from accounting books or bank statements).
•
However, often the timing of cash flow is in a different accounting period from the substance of the
transaction. Examples include selling inventory or providing services on credit; when a contractor
provides services for your company but will not be paid until a later accounting period. As noted (but
worth repeating), accrual accounting incorporates these complexities by recording revenues and
expenses at the time they occur, not when cash is received.
Benefits of accrual accounting
The differences between cash and accrual accounting are critical to your understanding, so the previous points
are worth reinforcing. The primary measure of a company’s performance is its profit for the period. Profit is
measured as revenues minus expenses. The key revenue for most companies comes from the sale of goods or
services. The amount of revenue recorded is the amounts expected to be received from providing the good or
service regardless of when the customer pays for the goods or services. Expenses represent the amounts paid
or owing by the organisation in order to earn the revenues. Some expenses may be paid at the time the
expense is incurred but often the amounts will be paid after, or even before, the expense is incurred. For
example, you may have done some casual work during the month which is not paid to you by the company
until the end of the month. On the other hand, the company will likely pay rent and insurance in advance.
The benefits of accrual accounting to the user of financial statements are:
• it includes all assets and liabilities in the balance sheet to give a truer picture of the financial position of
the organisation (e.g. accounts receivable and accounts payable)
•
it includes all revenues and expenses regardless of whether the cash has yet been received. For example,
if a company makes a large sale to an established customer who has always paid its bills, the company
would see this as a positive factor. Accrual accounting includes such a transaction in revenues and this
more accurately measures profits. Similarly, if the company has received the benefits of services from other
organisations then this should be included in expenses and, therefore, impact the performance measure.
•
assets are used over a number of years and will benefit the performance of each year. Therefore, in
measuring overall performance a share of the costs of that asset should be allocated across the life of the
asset. This allocation, called depreciation, is included in an accrual accounting system.
•
To compare cash profit with accrual profit, consider the following:
A company makes credit sales of $100 000 in June, and the cash will be collected in July. Under an
accrual system, $100 000 revenue would be included in June, whereas under a cash system the amount
would be recognised in July.
•
A contractor carries out repair work for your company in June for $20 000, but the bill will not be paid
until July. Under an accrual system, the expense would be recognised in June, but under a cash system it
would not be recognised until July.
•
Under accrual accounting there will be an allocation of the cost of equipment to expenses over several
accounting periods to recognise the consumption of the equipment’s future economic value. This is
10
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
called depreciation. If some new equipment cost $80 000 and has a life of eight years, $10 000
depreciation would be included in expenses each year.
Note that in both of the previous examples, the revenues or expenses are recognised under accrual
accounting before they would be recognised under cash accounting. In later chapters, we will work through
examples where a company receives cash before it earns the revenue and pays cash before it receives a
service.
HOW’S YOUR UNDERSTANDING?
1B In June, a company makes cash sales of $100 000 and credit sales of $200 000 (all to be collected in July). It pays
wages of $60 000 and owes $10 000 for June expenses (to be paid in July).
(i) What is profit using cash accounting?
(ii) What is profit using accrual accounting?
Using accrual accounting to prepare financial statements
Using the accrual accounting approach in preparing the financial statements, attempts are made to:
• include all the cash receipts and payments that have already happened; for example, cash sales and cash
payment for wages
•
incorporate future cash receipts that should be expected, based on existing transactions; for example, it is
necessary to include credit sales now, although the cash will not arrive until the next period
•
incorporate future cash payments that need to be paid for goods or services already provided to the
organisation
•
measure the value of incomplete transactions; for example, estimate the likely amount of accounts
receivable that will not be collected or the amount of inventory that is obsolete, and treat these amounts
as expenses of this year
•
estimate figures when exact amounts are unknown; for example, estimate the amount of interest due from
the bank at year-end, even though the bank does not add the interest to your account for another two
months – the amount is interest revenue
•
estimate the using up (consumption) of an asset over time (called depreciation), i.e. allocating the cost of
the asset to each year over the life of the asset.
Estimates and assessments
Notice the use of the words ‘estimate’ and ‘assessment’. This illustrates the need for judgements when
preparing financial statements under accrual accounting. Examples of estimates are as follows.
• The value of a bank’s overseas loans (i.e. the money actually to be received back from those loans). Not all
borrowings will eventually be repaid so the bank will need to estimate the proportion likely to be repaid.
This may depend on economic conditions at the time. Accountants study the loan repayment record of
various industries and large borrowers and then estimate how much money the bank will be able to collect.
•
The amount of profit that should be recognised during the year by a construction company for a major
bridge that will take two years to complete will depend on future expenses. Not all borrowings will
eventually be repaid so the bank will need to estimate the proportion likely to be repaid. This may depend
on economic conditions at the time. Accountants calculate the costs involved in building the bridge to this
point. Based on such estimates as the percentage of the job completed, he or she also estimates the total
likely profit of building the bridge and determines the percentage of profit to be included in this period.
•
All companies have to estimate the amount of money owing to employees at the end of each year for
wages where the work is done and not yet paid, and calculate the amount owing to employees to be
Get Complete eBook Download By email at student.support@hotmail.com
11
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
paid in the future for holiday pay, long service leave and superannuation (depends a lot on the type of
superannuation plan).
The importance of good judgement
Accrual accounting has been developed because financial statements cannot be based on merely the routine
accounting records of what has happened. Measuring economic performance is more complex than that, and the
appropriate measures can be elusive and complex judgements need to be made. Many augmentations
to the transactional record (estimates, adjustments, judgements and verbal explanations) must be made so that
the statements will be meaningful. The resulting statements, therefore, depend to a great extent on the
quality and fairness of such augmentations. Managers, accountants and auditors must use their judgement
constantly.
Financial accounting, because it relies on many judgements, is far more imprecise than most people (even
many regular users of financial statements) realise. To help students understand the reality of modern financial
accounting, this book spends much space on the real-life imprecisions of preparing and using financial
statements. Accrual accounting is therefore the presumed method in this book, though there will be some
comparisons between it and simple cash-based accounting. Modern financial accounting starts with cash
receipts and payments, then builds a very large accrual accounting process in addition to the cash records in
order to provide the sophisticated measures of financial performance and position that today’s world demands.
FOR YOUR INTEREST
Many of you will end up working as accountants or managers for organisations that operate in many countries. This book
should equip you to understand the financial statements prepared in most countries, including Australia, the United
Kingdom, Canada, New Zealand, China, Singapore, Hong Kong, Indonesia, Malaysia and many others. The methods of
preparing financial statements in these countries are very similar. All use the accrual accounting system introduced in
this chapter. With the introduction of International Financial Reporting Standards (IFRS) in 2005, differences between
financial reporting in these countries are likely to be very small.
1.6 The key financial statements
LO5 Organisations are required to provide the following types of information that are relevant to user needs:
financial position, financial performance, financing activities and investing activities.
The key financial statements that provide this information are: a balance sheet, which shows the financial
position at a point in time; an income statement, which measures financial performance over a defined
period (such as a month or a year) by deducting expenses from revenues during the period to obtain profit
for the period; and a statement of cash flows, which shows the sources and uses of cash during the period.
Both financing and investing activities are included in this statement.
Balance sheet
Exhibit 1.1 provides an example of a simple balance sheet, also called ‘Statement of Financial Position’. The
balance sheet shows an organisation’s resources and claims on resources at a particular point in time. The
heading provides the company name, the title of the report and the date at which the financial position is
shown. The three main elements of a balance sheet are assets, liabilities and owners’ equity. In this case, the
organisation is a company, and owners’ equity is described as shareholders’ equity. If the organisation were a
sole trader or partnership, it would be called proprietor’s equity or partners’ equity, respectively. You should
be aware that while some companies use the label ’Balance Sheet’ (e.g. Commonwealth Bank 2020 and
Qantas 2020) others use the label ‘Statement of Financial Position’ (e.g. Woolworths 2020 and Telstra 2020).
12
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
EXHIBIT 1.1
XYZ LTD
BALANCE SHEET AS AT 30 JUNE 2022
2022
2021
$000
$000
Cash at bank
2 000
1 400
Accounts receivable
16 000
13 000
Inventory
12 000
10 000
Property, plant and equipment
90 000
91 000
Total assets
120 000
115 400
Accounts payable
17 000
16 800
Assets
Liabilities and shareholders’ equity
Liabilities
Wages payable
2 000
2 000
Provision for employee entitlements
4 000
3 000
Long-term loans
30 000
33 600
Total liabilities
53 000
55 400
Share capital
40 000
36 000
Retained profits
27 000
24 000
Shareholders’ equity
Total shareholders’ equity
67 000
60 000
Total liabilities and shareholders’ equity
120 000
115 400
As a balance sheet is defined as a statement of financial position at a particular time, you should be familiar
with both terms.
ASSETS
Assets are a present economic resource controlled by an entity as a result of past events. An economic
resource is a right that has the potential to produce economic benefits. Subsequent chapters will provide
more information on assets and asset recognition. At this point, you should note that the value of every
asset needs to be measurable in monetary terms. A brief discussion of the assets in Exhibit 1.1 will make you
familiar with the terminology.
• The cash at bank account records deposits to and withdrawals from a bank.
•
Accounts receivable (also called debtors) represents amounts owing from customers for goods or services
provided to them. Accounts receivable is shown net, which indicates the amount that management
expects to collect from customers after allowances have been made for likely uncollectable amounts.
•
Inventory generally represents the cost of stock on hand; that is, unsold products.
•
Property, plant and equipment includes items such as land, buildings, equipment, motor vehicles,
computers and furniture.
Assets can be financed in one of two ways: liabilities and/or shareholders’ equity:
Assets = Liabilities + Shareholders’ equity
Get Complete eBook Download By email at student.support@hotmail.com
13
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
LIABILITIES
Liabilities are present obligations of an entity to transfer an economic resource as a result of past events. For
example, suppliers providing goods on credit and employees carrying out work are examples of past
transactions that lead to liabilities. Liabilities can be legally owed debts, such as loans from the bank or
amounts due to suppliers. However, they also can be estimates of future payments based on past
agreements, such as those arising from promises of future benefits to employees for long service leave, or of
warranty repairs for customers when products break down. Liabilities involve the future use of assets, usually
cash, or the performance of future services. An example of the former is paying cash to reduce a liability. An
example of providing a future service would be carrying out warranty repairs on products previously sold.
Four examples of liabilities in Exhibit 1.1 are accounts payable, wages payable, provision for employee
entitlements and long-term loans.
• Accounts payable (often called trade creditors) is the amount owed to various suppliers for goods or
services they have provided to an organisation.
•
Wages payable (also called accrued wages) is for work done by employees, but for which they have not
yet been paid.
•
Provision for employee entitlements refers to entitlements employees accumulate as a result of past work,
such as holiday leave, sick leave, long service leave and superannuation.
•
Long-term loans are loans that are not repayable within a year.
SHAREHOLDERS’ EQUITY
Shareholders’ equity is the excess of assets over liabilities. It is the residual interest in the assets of the entity
after deducting all its liabilities. Shareholders’ equity for a company consists of two main elements: share
capital and retained profits.
• Share capital is the amount that owners have directly invested in the company.
•
Retained profits represent the total cumulative amounts of profits that the company has retained in the
business rather than distributed as dividends.
The relationship between assets, liabilities and shareholders’ equity can be expressed in the following
accounting equation:
Assets = Liabilities + Shareholders’ equity
This equation shows that the resources of an organisation are funded from two types of sources: debt or
equity. The effects of transactions on this equation are discussed in Chapter 2. At this point you should note
that the equation balances at every point in time.
HOW’S YOUR UNDERSTANDING?
1C For each of the following items state whether they are assets (A), liabilities (L), shareholders’ equity (SE) or not
listed in the balance sheet:
(i) accounts receivable
(ii) accounts payable
(iii) sales revenue
(iv) share capital
(v) equipment
(vi) loans.
14
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
Comparative balance sheets
Note that the balance sheet in Exhibit 1.1 shows numbers for 2021 and 2022. The changes from 2021 to
2022 provide the reader with information about what is happening to various account balances; for example,
cash at bank has increased from $1400 to $2000. The statement does not tell us the reasons for the change,
but it is possible to obtain information on the change in this account in the statement of cash flows provided
in Exhibit 1.3 (to be discussed later). While some of the reasons for the changes in other balances are too
complicated for this introductory chapter, you will be able to understand the changes after you have
completed Chapters 2 and 3 (we will return to Exhibit 1.1 in Chapter 2). For now, consider some preliminary
ideas:
• What would be a likely explanation for the increase in accounts receivable? Most likely credit sales (this
would increase accounts receivable) are greater than cash received from customers related to credit sales
(this would decrease accounts receivable).
•
What does the increase in share capital mean? This normally indicates that there have been shares issued
during the year.
•
The long-term loans have decreased from $33 600 to $30 000, indicating the company has borrowed less
than it has repaid on the loans.
HOW’S YOUR UNDERSTANDING?
1D Consider the following questions:
(i) If the balances of total assets and shareholders’ equity are $100 000 and $40 000, respectively, what is the
balance of total liabilities?
(ii) If the balances of total liabilities and shareholders’ equity are $200 000 and $300 000, respectively, what is
the balance of total assets?
(iii) Given the balances of assets $300 000, liabilities $200 000 and share capital $60 000, what is the balance of
retained profits?
Income statement
The income statement is also called the ‘Profit and Loss Statement’. For example, while Telstra, Commonwealth
Bank and Qantas all use the label ‘Income Statement’ some large companies (e.g. Woolworths 2020) use the
Statement of Profit and Loss and internally many companies refer to the Profit and Loss Statement. In previous
years, the income statement was called the profit and loss statement. Some companies may continue to use
that terminology within their internal reports, so you should at least be aware of it.
The income statement provides information on an organisation’s profitability for a period of time. It
matches revenues during a period against expenses incurred in earning the revenues. The difference is the
profit (revenue greater than expenses) or loss (expenses greater than revenue). Recall that under an accrual
accounting system, the cash related to the revenue or expense does not have to be received or paid in
order for the revenue or expense to be included in the income statement. Discussion of when revenue and
expenses are recognised is included in Chapter 2.
Exhibit 1.2 provides an example of a simplified income statement. Sales is the only revenue item listed.
The next item in the income statement is cost of goods sold (COGS). For a retailer, this would be the cost of
the goods that are sold. For example, if a retailer sells 100 items at $20 each and the cost price of each of
the items is $8, sales revenue would be $2000 ($20 × 100) and cost of goods sold would be $800 ($8 ×
100). The difference between sales revenue and cost of goods sold is called gross profit (also gross margin).
Get Complete eBook Download By email at student.support@hotmail.com
15
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
EXHIBIT 1.2
XYZ LTD
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 2022
$000
$000
Sales revenue
21 000
Less Cost of goods sold
8 000
Gross profit
13 000
Less Operating expenses
Salaries
2 500
Depreciation
500
Electricity
300
Travel
300
Other
400
4 000
Operating profit before tax
9 000
Less Income tax expense
3 000
Operating profit after tax
6 000
The income statement also lists various operating expenses, as shown in Exhibit 1.2. These costs relate to
the day-to-day running of the business.
Many other operating expenses, such as advertising, staff training, maintenance, telephone and motor
vehicle expenses, could also be included. Deducting these operating expenses from gross profit gives
operating profit before tax. Tax is then deducted to give operating profit after tax.
The profit figure of $6 million can be paid out in dividends to shareholders or retained in the business.
This is the connecting link between the balance sheet and the income statement. The opening balance of
retained profits plus the profit for the year minus dividends equals the closing balance of retained profits as
shown in the balance sheet.
Companies provide a separate statement or note to the accounts showing the change in retained profit
for the year. For example, if XYZ’s opening retained profits were $24 million, net profit for the year was
$6 million and dividends of $3 million were declared and paid, we would see the following statement in
the notes to the accounts for retained profits.
$ million
Opening balance
24
+ Net profit
6
30
− Dividends declared and paid
3
Closing balance
27
HOW’S YOUR UNDERSTANDING?
1E Assume the opening balance of retained profits is $80 000 and the following account balances for the
month of February are: sales $200 000, cost of goods sold $90 000, wages expense $60 000 and other
expenses $10 000. What is the profit for the month of February and the balance of retained profits at the
end of February?
16
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
Statement of cash flows
Because revenues reported usually do not equal cash collected and expenses do not equal cash paid, net
profit is different from the change in cash for the period. The statement of cash flows shows the changes
during the period in one balance sheet account, namely cash. It shows the receipt of cash and the payment
of cash. Accounting standards require companies to present this statement in their published financial
statements. Individual transactions are normally split into the following three categories:
1 operating activities: related to the provision of goods and services
2 investing activities: related to the acquisition and disposal of certain noncurrent assets, including property,
plant and equipment
3 financing activities: related to changing the size and composition of the financial structure of the entity,
including equity and certain borrowings.
Exhibit 1.3 provides an example of a statement of cash flows. Under cash flows from operating activities, it
shows that the company received $17 million from customers, and paid $7.7 million and $2.5 million to
suppliers and employees respectively, as well as paying $4.3 million in other cash operating costs.
Note that these figures under cash flow from operating activities are not the same as those in the income
statement. For example, the company could have made $21 million in credit sales, but only collected $17
million from customers by the end of the year. For XYZ Ltd there is only one investing item, being the cash
paid for a new machine. Cash flows from financing activities show that the company received $4 million from
an issue of shares, but paid back a $3.6 million bank loan. The net effect on cash of all of the prior
transactions was an increase of $600 000. When added to the opening balance of $1.4 million, it shows a
closing balance of $2 million, which is also the figure shown under cash in the balance sheet. Statements of
cash flows will be discussed in detail in Chapter 7.
EXHIBIT 1.3
XYZ LTD
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 30 JUNE 2022
$000
Cash flows from operating activities
Receipts from customers
17 000
Payments to suppliers
(7 700)
Payments to employees
(2 500)
Other cash operating costs
(4 300)
2 500
Cash flows from investing activities
Purchase of machinery
(2 300)
Cash flows from financing activities
Issue of shares
4 000
Bank loan
(3 600)
400
Total net cash flows
600
Cash: 1 July 2021 (opening balance)
1 400
Cash: 30 June 2022 (closing balance)
2 000
Get Complete eBook Download By email at student.support@hotmail.com
17
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
Relationships between the financial statements
Exhibit 1.4 shows the main relationships between the various financial statements. We have abbreviated the
balance sheet, the income statement and the cash flow statement in Exhibits 1.1, 1.2 and 1.3 to make the
relationship clearer. The cash flow statement explains the change in cash in the balance sheet from $1400 to
$2000. This change will be from cash flows from operating, investing and financing activities, and a closer
examination of Exhibit 1.3 will show which cash flows have the major impact. Net profit of $6000 for the year
appears in the income statement, and this amount increases retained profits. How this works can be seen in
the note on retained profits, which has increased from $24 000 to $27 000, due to the net profit for the year
less the dividends declared and paid; that is, the amount of net profit not used for dividends increases the
balance of retained profits.
EXHIBIT 1.4
XYZ LTD
RELATIONSHIPS BETWEEN THE STATEMENTS (BASED ON EXHIBITS 1.1 TO 1.3)
2021
2022
Balance sheet
Cash
Cash flow statement
1 400
2 000
From operating activities
2 500
Other assets
114 000
118 000
From investing activities
(2 300)
Total assets
115 400
120 000
From financing activities
400
Liabilities
51 400
53 000
Total net cash flows
600
Share capital
40 000
40 000
Opening balance
1 400
Closing balance
2 000
Retained profits
24 000
27 000
Total liabilities and shareholders’ equity
115 400
120 000
Retained profits note
Income statement
2021 balance
24 000
Revenues
21 000
+ Net profit
6 000
Expenses*
15 000
30 000
Net profit
6 000
− Dividends
3 000
2022 balance
27 000
*From Exhibit 1.2, total expenses = COGS + Operating expenses + Income tax expense*
= 8000 + 2500 + 500 + 300 + 300 + 400 + 3000 = 15 000
HOW’S YOUR UNDERSTANDING?
1F If the opening balance in retained profits is $100 000, net profit after tax is $60 000 and dividends declared and
paid is $40 000, what is the balance of retained profits at year-end?
18
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
1.7 Accounting principles and the use
of accounting information
How do accountants decide what accounting is needed and then put their decisions into practice? This
section outlines the conceptual background that guides accountants. Doing accounting takes expert
knowledge, considerable experience and continuous attention to new problems and solutions. The business
environment is continually changing with organisations becoming more global, increased complexity in
financing and structuring of companies, new forms of product manufacturing, new forms of retailing (e.g.
online shopping) and even new forms of banking arrangements and new types of currencies. Therefore,
concepts and principles are very important in accounting, because they form a logical structure that
practising accountants use every day to consider problems, make or recommend decisions and explain
solutions.
Applying accounting standards and principles depends on the particular accounting entity: the
organisation for which the accounting is being done. The local coffee shop needs accounting information, as
do the groups of corporations making up BHP, Woolworths or Westpac, but decision criteria would imply
different accounting needs for the coffee shop entity, the resources company, the retailer or the bank, so
generally accepted accounting principles would be applied differently for these entities.
Financial accounting has a surprisingly large set of concepts and principles to guide accountants in
preparing financial statements, auditors in verifying them and users in interpreting them. A very large
amount has been written about the conceptual and theoretical side of accounting and several groups are
involved in setting financial accounting standards and otherwise regulating accounting information.
This section will give you a glimpse of the conceptual structure behind financial accounting by focusing
on some concepts of particular value to the users of accounting information. These concepts have been
deduced by accountants, researchers and standard-setters from logic and the observation of good practices,
and they are used to guide everyone who prepares, audits, uses and studies financial accounting.
A phrase often used in relation to accounting’s conceptual structure is ‘generally accepted accounting
principles’ (GAAP). These are the rules, standards and usual practices that companies are expected to follow
when preparing their financial statements. They are a combination of the authoritative standards and
concept statements issued by accounting standard-setters – such as the Australian Accounting Standards
Board (AASB) – and the accepted ways of doing accounting that are not included in such standards. Year by
year, the set of authoritative standards gets larger, but the world continues to increase in complexity, so the
standards are never extensive enough to include everything. In fact, it is generally argued that they should
not try to cover everything, because if they did, financial accounting would be bound by an inflexible set of
rules that are unlikely to be able to cope with change. Thus, the setting of accounting standards is usually
considered to be ‘principles’ based rather than ‘rules’ based.
The development of GAAP can be traced back to the evolution of financial accounting, as well as to the
efforts of standard-setting bodies that attempted to improve accounting principles and practices by
increasing the authoritative, documented part of GAAP. Until the 20th century was well underway,
authoritative accounting standards did not exist. The catalyst that produced increased financial disclosure
and brought more rules governing it was the US stock market crash of 1929. Poor financial reporting and
disclosure were seen as contributing to the crash. It was argued that, had investors been better informed,
they could have made sounder financial decisions, thus preventing the stock market collapse and its harmful
economic and social consequences.
In Australia, the main GAAP consist of accounting standards and the conceptual framework. It all sounds a
bit complex, but if we describe them one by one it should become clearer. Think of them as a package that
together forms GAAP.
While, for many years, there were significant differences in accounting standards between countries, the
establishment of the International Accounting Standards Board (IASB) resulted in a whole series of new
accounting standards. In Australia (and in many other countries), the local standard setter uses the IASB
pronouncements as the ‘foundation’ pronouncements, to which it adds material detailing the scope and
Get Complete eBook Download By email at student.support@hotmail.com
19
LO6
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
applicability of a pronouncement in the Australian environment. Additions are made, where necessary, to
broaden the content to cover sectors not addressed by an IASB pronouncement, and any domestic,
regulatory or other issues.
General concepts and principles to be used in preparing and presenting financial statements are set out
in the Framework for the Preparation and Presentation of Financial Statements. (This is cited in the Australian
Accounting Standards and in this book as ‘the Framework’.) This Framework has important implications, so we
now devote a complete section to its coverage.
1.8 Framework for the preparation and
presentation of financial statements
LO7 The Framework issued by the AASB sets out the concepts that underlie the preparation of financial reports for
external users. The Framework starts with coverage of the objectives of financial reporting and the qualitative
characteristics of the useful financial information. We discuss these topics in the following paragraphs.
The Framework makes a distinction between general-purpose financial statements and special purpose
financial statements. The Framework deals with general-purpose financial statements (as does this book). These
general-purpose financial statements are aimed at the common information needs of a wide range of users.
These users generally have to rely on the financial report as their major source of financial information. Special
purpose reports, such as prospectuses for the issue of shares, are outside the scope of the Framework.
You have already been introduced to the users of financial reports. These include: investors, employees,
lenders, suppliers and other trade creditors, customers, governments and their agencies, and the public. The
Framework takes the view that investors, lenders and other creditors are the main users of the financial
reports, as the objective of general-purpose financial reports is to provide information to existing and
potential investors, lenders and other creditors to allow them to make decisions about providing resources to
the organisation.
The Framework also recognises that the users of information about not-for-profit organisations may be
different and their resource allocation decisions may differ. For example, they include donors, taxpayers,
recipients of the services (e.g. the community) and parties providing an oversight role (e.g. Parliament).
The objective of financial reports as outlined in the conceptual Framework is to provide information about
the financial position, financial performance and cash flows that is useful to the aforementioned users
(including existing and potential investors, lenders and other creditors) in making economic decisions.
These economic decisions, which will vary depending on the user, generally require an evaluation of the
ability of the entity to generate cash in the future. Users are interested in the timing of that cash generation
and the level of certainty; that is, how likely it is that the cash will be generated. This future cash generation
is an important determinant of the ability of the entity to pay dividends to shareholders, wages to
employees, interest to lenders and tax to the government. The Framework argues that decisions by potential
users depend on the returns they expect (e.g. dividends, interest and capital gains/losses) and that
expectations about returns depend on the assessments about the amount, timing and uncertainty of future
cash flows.
To help predict future cash flows, users need to know about:
• the economic resources (e.g. land and buildings, equipment and patents) that the entity controls
•
the claims against the entity (e.g. amounts owing to others such as banks and suppliers) and how
effectively and efficiently management and the board have discharged their duties
•
information about the nature and amounts of these resources and claims. This information helps users
identify strengths and weaknesses (including liquidity and solvency which are discussed in Chapter 6),
and its need for additional finance and likelihood of attaining it.
20
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
In addition to knowing about the present level of resources and claims, users also need to know about
changes in these amounts from both financial performance and other transactions such as borrowing money
(e.g. bank loans) and issuing shares. Information on financial performance (as measured by calculating the
profit from the organisation) is useful for two main reasons:
• It helps users understand what return shareholders get on their equity (return on equity), which indicates
how efficiently and effectively the organisation has used its resources.
•
Information about the variability of these returns and its components (discussed in detail in Chapter 6
under ratios) helps assess future cash flows.
1.9 Qualitative characteristics of useful
financial information
The Framework, which was revised in May 2019, notes that qualitative characteristics of useful financial
information are the attributes that make the information in the financial reports useful to users. It lists two
fundamental qualitative characteristics: relevance and faithful representation. In addition, it notes that
comparability, verifiability, timelines and understandability are characteristics that enhance the two
fundamental characteristics.
In summary, the qualitative characteristics set out in the Framework are:
• Fundamental qualitative characteristics:
– relevance
– faithful representation.
•
Enhancing qualitative characteristics:
– comparability
– verifiability
– timeliness
– understandability.
If information is to assist users in making decisions about the allocation of scarce resources, it should help
them make, confirm or correct predictions about the outcomes of past, present or future events. Information
is relevant if it is capable of making a difference in a decision by users of the accounting reports. To make a
difference, it needs to have predictive and/or comparative value. Predictive value means it is useful as an
input to making a decision. For example, information on sales revenue is likely to help an investor decide
whether to buy or sell shares. The level of present liabilities may be useful for a lender in deciding whether
to provide further borrowings to a company. Financial information also has confirmatory value as it provides
feedback on previous evaluations, i.e. it confirms or changes the view of the decision making. This year’s
sales figures can have both predictive value (used as a basis for predicting future revenue) and confirmatory
value when being compared to previous predictions of the present year’s sales.
The financial statements should not be deliberately misleading. They should not be designed to lead
users towards conclusions that are desired by the preparers. This is the criterion of ‘faithful representation’.
The financial statements should report the economic substance of events happening to the company, and
the numbers should measure the events neutrally, neither overstating nor understating their impact.
Information should, without bias or undue error, faithfully represent those transactions and events that have
occurred. To have perfect faithful representation, the financial information needs to be complete, neutral and
free from error. While such perfection is seldom completely achievable, the board of directors’ objective is to
maximise these qualities.
Complete means that it includes all necessary information so that the user can understand the
phenomenon being depicted. This becomes a professional judgement on how much detail needs to be
given to be complete. Neutral refers to the definition of information without bias in which information is
presented. Free from error means that there are no errors or omissions in the description of the
Get Complete eBook Download By email at student.support@hotmail.com
21
LO8
LO9
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
phenomenon and the process to produce the information is accurate. It is important to note that information
cannot be perfectly accurate, as there are many estimates in financial statements (to be discussed later). An
estimate can still be a faithful representation if the description is accurate, the nature and limitations of the
estimates are described and the processes used to produce the estimates are accurate.
In discussing relevance, it is important to understand the concept of materiality. The materiality concept is
concerned with assessing whether omission, misstatement or non-disclosure of a piece of information would
affect the decisions of users of the accounting reports. Just what is or is not material is a matter of
judgement, and has been the subject of considerable research and study by accountants and auditors.
Usually, people judge materiality by considering the size of a possible error compared to the net profit or
the total assets. For example, an accountant or auditor might judge that an error over 5 per cent of net
profit or 1 per cent of total assets is material but an error smaller than that is not. The Framework specifically
states that it cannot specify a uniform quantitative threshold for materiality. In practice, what is material is a
matter of professional judgement that accountants and auditors need to make. The materiality judgement
depends on any particular uses of the information that are expected, and on whether the error moves the
profit to a loss or violates some condition in a loan agreement.
In the list that follows, we elaborate on the four enhancing qualitative characteristics (based on the
Framework).
• Comparability: information about one organisation is more useful when it can be compared with similar
information from another organisation and also is comparable over time within the same organisation. In
terms of comparability, GAAP contains many detailed rules with several industry exceptions and
alternative accounting policies for the same transactions. All these exceptions and alternative treatments
certainly lead to some difficulties in making comparisons across companies. Analysts often come up with
their own standard way of presenting accounting data by taking published financial data and converting
it to their own requirements. Comparability is not the same as consistency, which refers to using the same
methods consistently over time or using the same methods in a single period across different parts of the
organisation. However, this consistency of the use of methods will help achieve the goal of comparability.
•
Verifiability: the numbers in the financial statements can be verified directly by looking at documentation
(e.g. the cost price of equipment) or through direct observation (e.g. counting cash or inventory). They
can also be verified indirectly by checking inputs to a model formula and recalculating the outputs.
Indirect verification would be the checking of the inputs to a model or formula and then using the same
methodology recalculating the outputs.
•
Timeliness: refers to having information available when users need to make their decisions. However, having
information earlier rather than later can mean that it is less complete. For example, certain estimates
become more accurate over time (e.g. the estimate of uncollectable accounts receivable, to be discussed
in Chapter 11, or the obsolescence of inventory, discussed in Chapter 12 or estimates of depreciation of
assets, discussed in more detail in Chapter 13). Liabilities related to certain past acts may also become
more accurately measured as time passes (e.g. after court deliberations). However, the characteristic of
timeliness incorporates the idea that it is important to have the information when the decision is being
made even though there may be considerable uncertainty about the amount reported. For example, some
of the decisions by the board of directors, the analyst, and the banker and the supplier noted earlier need
to be made at a certain point in time. While the outcome of a particular contract may be relevant
information, the decisions often cannot wait until that contract has been finalised.
•
Understandability: information is more useful if informed decision-makers can understand it.
Understandability can be increased by presenting information in a clear and concise manner. The
Framework states that users are expected to have a reasonable knowledge of business, economic
activities and accounting, and a willingness to study the information with reasonable diligence. However,
there is a caveat to understandability: information about complex matters, if relevant to users, should not
be excluded on the grounds that it is too difficult for users to understand.
The accounting profession has been criticised for the increased complexity of financial reports, where the
notes to the accounts can exceed 50 pages. One reason for this is the increased complexity of transactions
22
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
and the increased need for estimates. For example, when senior executives are only paid a salary, reporting
executive remuneration is much easier than when they get additional share options and various incentives
based on accounting numbers. Also, given the legal consequences and penalties for omission of required
data, it is likely that management will over-report rather than under-report when there is uncertainty about
the level of detail required. Boards of Directors do not want to be accused of not following ‘best practice’
and so if one company in the industry decides to make additional disclosures, other companies often follow.
How to manage this complexity is an ongoing consideration for those who set accounting standards.
What does all this mean for you as an introductory accounting student? These accounting standards are
continually being considered around the world. Some important changes in accounting have already
occurred and others are still emerging. Accounting is not static; the better you understand the basic
fundamentals of accounting, the better you will be able to cope with these changes. So, terms such as
relevance, faithful representation, comparability, verifiability, timeliness and understandability may appear
complex when reading Chapter 1 but they should become clearer as you work through the chapters.
Trade-offs among accounting principles
If you think about the qualitative characteristics mentioned (i.e. relevance, faithful representation,
understandability, and comparability), you may see that they do not always fit together well. For example, it
would seem sensible to propose that the more faithfully representative the accounting information is, the
better. You can achieve this by being very careful about how you prepare it, checking it carefully and having
the auditors come in and verify it, and maybe even waiting until some major uncertainties are resolved, so
you do not have to estimate them. It also seems sensible that decision-makers need information that is
relevant to their decisions when they are making them. This means that information should be timely: people
should not have to wait for the information they need.
In this light, let’s consider a company trying to report on its liability to employees for long service leave.
Generally, in Australia employees who stay at the one company for over 10 years accumulate additional
leave based on the time at the company. This is called long service leave; it accrues in days of leave and is
only paid when the employee takes the leave (e.g. as extra holidays) or finishes employment with the
organisation. The company has thousands of employees who will take this time off over the next 40 years, if
they do not leave the employer earlier. The dollar amount of long service leave paid will depend on how
much the employees earn when they take the leave, and that is not yet known for most of them. The
amount of leave depends on how long the employees have been with the firm. Under most employment
awards, it starts to accumulate after 10 years of service. For each extra year of service, it increases at
different rates. If the employee leaves before 10 years of service, no amount normally needs to be paid
unless the employee’s leaving was involuntary.
How is that for a mass of uncertainty? Any number you come up with for the long service leave liability
will be based on all sorts of estimates of unknown future events. Therefore, to get a liability figure that
faithfully represents the liability, you really have to wait 20 or 30 years until most of the employees have
retired or taken their leave. You can always expect to get more reliable data by just waiting a while, even
years, to see how things turn out. But waiting 20 or 30 years will hardly provide timely information that is
relevant to decisions such as those being made by the board of directors, the investment analyst, the banker
and the supplier mentioned above. Such decisions require the best information we can come up with now,
even if it is necessarily based on estimates and assumptions. The longer one waits to make the estimate,
faithful representation rises and relevance falls, so we have to try to find some midpoint where there is
enough of both, even though we may prefer even more of one or both of these attributes.
1.10 Financial statement concepts
Now that you have seen the financial statements and the basic principles upon which accounting relies, it is
important to understand some basic assumptions underlying current accounting practice and the preparation
Get Complete eBook Download By email at student.support@hotmail.com
23
LO8
LO9
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
of financial statements. The following concepts are discussed: accrual basis, going concern, accounting entity,
accounting period, monetary and historical cost.
• Accrual basis: financial reports are prepared on the accrual basis of accounting; that is, the effects of
transactions and other events are recognised as they occur, regardless of whether cash is received or
paid at that time. The use of accrual accounting provides a better basis for assessing an entity’s past and
future performance than information only related to cash receipts and cash payments during a period.
•
Going concern: financial statements are prepared on the premise that the organisation will continue
operations as a going concern in the foreseeable future. If this is not the case, it is necessary to report
the liquidation values of an organisation’s assets, i.e. what the assets could be sold for. Consider the
following example. Assume last year your university completely remodelled your classrooms with new
carpet, tiered seating and new inbuilt projection equipment. Under historical cost, the cost of all those
renovations would be recorded as an asset and then depreciated over the life of the asset. If the costs
were $10 million and depreciation in year 1 was $1 million, the book value (cost – accumulated
depreciation) would be $9 million. This is the amount that would appear on the balance sheet. However,
if the government closed your university – that is, it is no longer a going concern – the assets would
need to be recorded at liquidation value. Basically, they would be recorded at what they could be sold
for. Note that there is not much of a second-hand market for tiered seating to fit a certain size of room,
or carpet that has been cut to fit that room. Liquidation value in this case would likely be a lot less than
historical book value.
•
Accounting entity: under this concept, the accounting entity is separate and distinguishable from its
owners. For example, the accounting entity of a sole trader is differentiated from the financial affairs of
the owner. Similarly, a company is a separate entity from its shareholders. If either the sole trader or a
shareholder of a company goes out and buys a new set of golf clubs, it may affect his or her personal
finances but does not affect the accounting entity. Accounting entities do not necessarily correspond to
legal entities. For example, as noted previously, the personal financial affairs of the sole trader can be
separated from the finances of the business, although there is no legal distinction. This concept puts a
boundary on the transactions that are to be recorded for any particular accounting entity. It also allows
the owner to evaluate the performance of the business.
•
Accounting period: the life of a business needs to be divided into discrete periods to evaluate
performance for that period. Dividing the life of an organisation into equal periods to determine profit or
loss for that period is known as the accounting period concept. The time periods are arbitrary, but most
organisations report at least annually, with large companies preparing half-yearly and quarterly financial
statements for outside purposes (in some countries) and at least monthly (sometimes more frequently)
financial statements for management purposes.
•
Monetary: accounting transactions need to be measured in a common denominator, which in Australia is,
not surprisingly, the Australian dollar. This allows comparisons across periods and across different
companies. Transactions that cannot be reasonably assigned a dollar value are not included in the
accounts.
•
Measured bases: under the historical cost concept, assets are initially recorded at cost. As you will see in
later chapters, many assets, such as inventory, will still be recorded at cost in the balance sheet in
subsequent periods although their value has increased. Some other assets – such as property, plant and
equipment – can be revalued periodically. Thus, in reading a balance sheet it is important to note at
what valuation the assets are being recorded (valuation methods including ‘cost’ and ‘fair value’ are
discussed in later chapters).
Some of these basic concepts have already been briefly mentioned earlier in this chapter, and all will be
referred to again throughout the book. We note that the Framework only lists accrual accounting and going
concern as the basic assumptions of financial reporting, but many authors, including us, would also include
the accounting entity, accounting period, monetary assumptions and historical costs.
24
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
1.11 Is accounting really important?
In case you are not convinced that accounting numbers (profit and balance sheet figures) are important, we
hope the following examples may convince you. Concrete examples of our suggestions appear in the
financial section of most newspapers every day. Our examples that follow show that a lot of emphasis is
placed on accounting figures (especially profits) in decision-making by management and by users such as
shareholders and creditors, corporate boards and consumer groups, as well as their impact on a range of
other community groups.
a Used by management in making business decisions. Accounting numbers have an important impact on
management decisions to contract and expand the business, which in turn affect employees, suppliers,
contractors and the economy. For example, the availability of large sums of cash, undrawn debt facilities,
and growing cash flows enable companies to take advantage of opportunities to expand by acquiring
other businesses. On the other hand, businesses are often put up for sale when they cannot provide the
financial performance (as measured by accounting numbers) to give investors the return they want, or
they take actions including cutting staff numbers and/or selling off some other parts of the business.
LO10
b Used by shareholders for decision-making purposes (and impact on shareholders). Both good and bad
accounting news often has a big impact on the share market (see Chapter 8 for a more sophisticated
discussion). In particular, when companies announce bad news their share prices are usually adversely
affected and sometimes the drops can result in a $100 million plus decrease in the value of the company.
c Used by bankers and other creditor groups. Bankers use accounting numbers to decide whether to lend,
to determine the level of risk and often the interest rate to charge. Rating agencies such as Standard &
Poor’s and Moody’s use accounting numbers to give their credit ratings, which have an impact on the
interest rates companies have to pay. Weaker accounting numbers can result in the loss of the much
desired AAA credit rating. This applies not only to companies but State governments which have received
warnings about ongoing deficits, growing risk and the decline in debt ratios.
d Used by corporate boards in rewarding and removing executives. Most executive compensation schemes
include performance bonuses, and accounting numbers are key components of these performance
hurdles. You will find many reports of pay changes of many millions of dollars for CEOs of the largest
companies due to meeting or not meeting profitability targets.
e Used by unions and management in negotiating wage agreements. In pay disputes, both managers and
unions often use accounting numbers to support their case. For example, the higher the profits, the more
likely the pay increases. Unions often refer to the company’s high profit levels when arguing for higher
wages.
f Impact on the community and consumers. Dwindling profits have resulted in movement of sporting events
(e.g. moving the Australian Grand Prix), changing budget allocation to TV stations which affect the
programs they offer, music festivals cancelled in future years, etc.
g Impact on employees and jobs. Accounting numbers can lead to corporate failure, with resulting
consequences for workers. In Australia, there have been major losses of jobs in the car manufacturing
industry which has been closed down due to falling profits. For example, cessation of manufacturing of
Holden resulted in the loss of approximately 3000 jobs at Holden, but many other job losses in
companies that were suppliers of tyres, steering wheels, etc.
1.12 Financial management and the
finance function
While accounting and finance are generally separate disciplines of study and research in most universities, the
terms ‘accounting function’ and ‘finance function’ in most large companies have tended to merge and are
Get Complete eBook Download By email at student.support@hotmail.com
25
LO10
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
often referred to as ‘the Finance Department’. For example, the finance function at most large universities
refers to all accounting processes related to the production of a set of financial statements, oversight of
financial controls, investment decisions, raising of finances and investing funds, management of cash,
budgeting, etc.
Within most large organisations, there will be a manager for the finance function who is a vital part of the
senior management team. This person plays a key role in planning and decision-making processes in their
organisation. This person will generally be called the chief financial officer (CFO), financial controller or chief
accountant. The work done by these financial managers is often referred to as ‘financial management’.
Financial management involves managing the finances of the organisation to achieve its strategic goals
and objectives. It includes preparing financial reports, setting financial goals and budgets, analysing
performance data and implementing financial controls, managing cash flow and investment discussions, as
well as making decisions about borrowing money and raising capital.
Core knowledge for the financial manager is an understanding of the content of financial statements and
the ability to analyse these financial reports for decision making. With this core knowledge, the financial
manager will carry out a wide array of functions including:
• determining the capital requirements of the organisation, based on present and future estimates of
financial performance and financial position
•
establishing financial controls, which will include the oversight of internal controls and the use of
techniques such as ratio analysis and financial forecasts
•
obtaining sufficient funds to meet the organisation’s needs and determining the composition of those
funds (e.g. debt versus equity financing)
•
cash management, including managing the cash flow cycle of the organisation and cash budgets
•
capital investment management, including capital budgeting decisions to determine in which long-term
projects to invest
•
non-financial reporting and analysis to achieve the organisation’s strategic goals and long-term value
creation targets.
1.13 Do you really need a knowledge of
accounting and financial management?
LO10 Let’s start with a very strong statement: It is highly likely that accounting numbers will have a big impact on
your life and career, no matter what path you take. In life, accounting numbers impact the returns you can
expect to earn from share market investments (in this case, accounting numbers for listed organisations), the
amount you can borrow to purchase a home or start a business (in this case, your own accounting numbers –
think revenue less expenses and any assets you hold as potential security) and the financial plans you make
and manage for your future.
Now to your career: first, the security of your job will depend not only on your performance in the role,
but most certainly on the financial performance of the organisation for which you work. Regardless of the
area of management you end up pursuing, accounting numbers are likely to affect you. If you take an
accounting/financial management path, accounting numbers will shape and inform each decision you make,
enabling you to make a valuable contribution to your organisation.
But what if you decide you do not want to take up an accounting/financial management role? Say, you are
more interested in marketing, economics, information technology or consulting. In this case, there will almost
certainly be financial consequences to most management decisions and, therefore, you will need a
fundamental understanding of accounting and financial management to know the likely financial implications
when considering alternative proposals. Also, we can assure you that as you take on more senior roles,
accounting numbers such as the profit of the organisation will affect your remuneration (e.g. go to the
26
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
annual report of any company and look at the company’s remuneration report and you will see that senior
management remuneration figures are closely linked to accounting numbers). You need to know how those
accounting numbers are determined and what actions improve those numbers. Would you play cricket,
tennis, football or netball without knowing the rules of the game? If you have the goal of becoming a CEO
or Director of a company, you cannot survive without basic financial management skills and the ability to
interpret financial reports.
Maybe you have great sporting or artistic ability, and this will be your career choice. The last two years
have seen numerous newspaper articles written about how the financial statements of organisations like
Cricket Australia, Australian Rugby League, Australian Rugby Union, Opera Australia, the Australian Ballet
and various entertainment facilities face financial difficulties and that their present balance sheet and profit
figures may not allow them to pay their highly skilled employees what they had previously earned. In some
instances, there has been turnover in senior executives as new solutions are looked for to address the
financial difficulties faced.
As an example of the effect of the financial numbers on both administration and players, consider the
situation for Cricket Australia during the pandemic when there were large restrictions on crowds at matches
and many matches needed to be cancelled. On the basis of the annual report and various newspaper
articles, the need to strengthen Cricket Australia’s financial position during COVID-19 was highlighted. Match
attendance was affected with revenues reduced, and costs increased with additional items such as
biosecurity-related expenses. To manage these financial shortfalls, Cricket Australia required financial
management initiatives, including: a large number of redundancies in Head Office including senior
executives; player salaries are tied to revenues, so any drop in revenues adversely affects their earning
capacity; and the grants from Head Office to each State cricket association decreased with consequent
negative effects on junior cricket.
If you work in the public sector or for not-for-profit organisations including charities, the level of activity
that your organisation can support will depend on its financial performance. As a general rule, your expenses
cannot exceed revenues (including donations received).
Finally, even if you decide to move into politics, you need a good understanding of financial statements.
Much of the support for business during the pandemic, including the Jobkeeper Program, incorporates
different levels of payments based on changes in accounting numbers (e.g. percentage drop in revenues).
Discussion between federal and state governments has incorporated the strength of balance sheets. In
August 2020, various newspaper reports referred to comments by Josh Frydenberg, Federal Treasurer, who
when outlining support provided by the federal government suggested that some states should contribute
more. For example, it was suggested that Victoria’s balance sheet was strong enough to do so. The strength
of the balance sheets of both companies and governments affects the credit ratings of these organisations
(e.g. A, A-, etc.), which in turn affects the interest rate at which funds can be borrowed.
Have we convinced you that accounting numbers are important to you and financial skills will help you in
any career?
FOR YOUR INTEREST
The Commonwealth Bank of Australia 2021 Annual Report (page 71) sets out a list of skills and experience considered
essential to the effectiveness of its Board of Directors (https://www.commbank.com.au/content/dam/commbank-assets/
about-us/2021-08/2021-annual-report_spreads.pdf). Listed below are five of these skills relevant to this book.
1 Financial acumen (including proficiency in financial accounting and reporting);
2 Governance (including understanding the regulatory frameworks underpinning corporate governance principles);
3 Risk management (including identifying, assessing and monitoring financial risks);
4 People and culture (including remuneration and reward risks), and
5 Environmental and social (understanding potential risks from an environmental and social perspective).
In this book you will learn the fundamentals related to these skills as a great start to a successful career.
Get Complete eBook Download By email at student.support@hotmail.com
27
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
PRACTICE PROBLEMS
Solutions to practice problems can be found at the end of the chapter. These problems are intended to
facilitate self-study and additional practice: don’t look at the solution for any of these without giving the
problem a serious try first, because once you have seen the solution it always looks easier than it is.
PRACTICE PROBLEM A
Classification of items
Listed below are balances at 30 June 2022.
$
Cash at bank
210 000
Inventory
60 000
Sales
210 000
Wages
40 000
Cost of goods sold
70 000
Share capital
140 000
Accounts payable
30 000
1 Classify each account as an asset, liability, revenue, expense or equity.
2 Prepare an income statement for the period ending 30 June 2022.
3 Prepare a balance sheet at 30 June 2022.
PRACTICE PROBLEM B
Accrual profit
1 During the accounting period, Green Limited received $750 000 from sales and paid out $580 000 in
wages and other expenses. However, an extra $260 000 worth of sales were made during the year but the
cash has not been collected yet. The company also owes $240 000 for various expenses. What is the
accrual profit?
2 Green Limited purchased 3000 items for $5 each on credit and sells 2000 of these items on credit for $8.
What is the sales revenue and cost of goods sold for the period?
PRACTICE PROBLEM C
Calculate shareholders’ equity
Given the following information relating to Penguin Ltd, what is the balance of shareholders’ equity?
(Remember A = L + SE)
$
Property, plant and equipment
28
1 500 000
Accounts receivable
400 000
Cash
100 000
Inventory
500 000
Bank loan
250 000
Wages payable
90 000
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
HOMEWORK AND DISCUSSION TO DEVELOP
UNDERSTANDING
This section starts with simpler discussion questions that revise some of the basic concepts, which are then
followed by a set of problems.
DISCUSSION QUESTIONS
1 What is the basic purpose of financial accounting?
2 Distinguish between financial performance and financial position.
3 What is the difference between financial and management accounting?
4 Who are the main parties that comprise the social setting of accounting?
5 What is meant by credible periodic reporting? What prevents organisations from making financial
statements increasingly credible? (Consider cost–benefit implications.)
6 List four important users of financial accounting and describe the use that each user would make of the
information.
7 Do all users of financial accounting have the same information needs? Why or why not?
8 List some similarities and differences between the need for financial information for shareholders and
bankers.
9 List five situations in which judgement is required by the preparers of financial information.
10 What does an audit achieve?
11 Describe what is meant by accrual accounting. How does it differ from cash accounting?
12 Who uses accrual accounting?
13 Consider the following accounts: accounts payable, accounts receivable, cash and inventory. Which of these
terms would you see in financial statements prepared under (a) accrual accounting and (b) cash accounting?
14 What are the three key financial statements, and what relevant information do they provide to users of
accounting reports?
15 Explain, in simple terms, each of the following financial accounting terms:
a
accounting entity
b accounting period
c
going concern
d materiality.
16 What are the fundamental qualitative characteristics of useful financial information and what are the
enhancing characteristics?
17 Provide an example of trade-offs among accounting principles.
18 The Framework states that understandability is an enhancing qualitative characteristic. Is this consistent with
the huge complexity in financial statements?
19 What other labels are used to describe a ‘balance sheet’ and an ‘income statement’?
PROBLEMS
PROBLEM 1.1
What are various people’s interests in financial accounting?
Briefly describe what each of the following people would likely want to learn from the financial statements of
BrandX Ltd, and how each might be affected if the statements showed good or bad financial performance or
financial position.
1 The chief executive officer (CEO) of the company
2 The company’s chief financial officer (CFO)
Get Complete eBook Download By email at student.support@hotmail.com
29
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
3 The chairperson of the company’s board of directors (the board evaluates the CEO’s performance on behalf
of the shareholders)
4 The partner of the auditing firm for whom BrandX is a client
5 The local manager of tax collections for the Australian Taxation Office
6 A shareholder who owns 100 shares of BrandX
7 A shareholder who is thinking of buying some shares of the company
8 The local manager of Big Bank, which has made a large loan to BrandX
PROBLEM 1.2
What are various people’s interests in financial accounting?
Briefly describe what each of the following groups would like to know from the financial statements of the
Swans Football Club.
1 The CEO
2 The players
3 The supporters
4 The suppliers of gourmet pies and beer for home games
PROBLEM 1.3
Users and their needs
Accounting information is demanded by a wide range of external users, including shareholders, bankers,
suppliers, trade unions, the Australian Securities and Investments Commission (ASIC) and the Australian
Taxation Office (ATO). Which user is likely to seek each of the following types of information?
1 The profitability of each division in the company
2 The likelihood of the company meeting its interest payments on time
3 The prospects for future dividend payments
4 The probability that the company will be able to pay for its purchases on time
5 The profitability of the company based on the tax law
6 The change in profitability of the company since the last contract with employees was signed
7 The disclosures on the financial position and performance of a company issuing shares to the public for the
first time.
PROBLEM 1.4
Calculate accrual accounting profit
Paul Jones set up his own catering business on 1 July 2021. During the 12 months up to 30 June 2022 the
following transactions occurred:
1 Paul put $30 000 of his own money into the business.
2 He borrowed $40 000 from the bank for one year at 5 per cent per annum, with interest to be paid at the
end of the loan.
3 He paid $12 000 in wages and owed $2400 in wages for work done.
4 He bought catering equipment for $8000, which has an expected useful life of four years.
5 He paid other expenses of $10 000.
6 Paul sent bills for $60 000 to customers for work performed between 1 July 2021 and 30 June 2022. By
30 June he had received $55 000 and expected the other $5000 by August.
Using the concepts of accrual accounting, calculate Paul’s profit for the year ended 30 June 2022.
PROBLEM 1.5
Accrual profit
Lock Limited made cash sales of $650 000 and credit sales of $270 000 ($150 000 of which had been collected
by year-end). It paid $400 000 in expenses and owed $220 000 at year-end. What was the accrual profit?
30
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
PROBLEM 1.6
Calculate accrual accounting profit
James Smith started a consulting business on 1 January 2022. During the period up to 30 June 2022, the
following transactions occurred:
1 James put $100 000 of his own money into the business.
2 He borrowed $40 000 from the bank at 10 per cent per annum for one year with interest to be repaid at
the end of the loan.
3 He sent bills for $37 000 to customers for work performed. By 30 June he had received $29 000 and
expected the other $8000 in July.
4 He bought equipment for $8000 that has an expected useful life of four years.
5 He paid $17 000 in wages.
6 He paid other expenses of $12 000.
7 He received a $3000 bill for advertising (appeared in newspapers in May; will be paid in July).
Using the concepts of accrual accounting, calculate James’ profit for the six months ending 30 June 2022.
PROBLEM 1.7
Accrual profit
1 During the year ended 30 June 2022, French Horn Ltd made cash sales of $100 000, credit sales of
$200 000 ($40 000 of which were still to be collected at year-end), and received $28 000 owing from
credit sales, which occurred in May 2021. What is French Horn’s sales revenue for the year ended 30 June
2022?
2 Also during the year ended 30 June 2022, French Horn paid $60 000 and owed $10 000 in employee
wages. Of the $60 000 paid, $5000 related to wages payable as at 30 June 2021. What is the total of
French Horn’s accrual accounting expenses?
3 What is French Horn’s accrual accounting profit for the year ended 30 June 2022?
PROBLEM 1.8
Prepare a balance sheet and calculate profit
1 Given the following balances, prepare a balance sheet as at 30 June 2022 for Willow Tree Limited.
$
Share capital
260 000
Bank loan
40 000
Accounts payable
90 000
Wages payable
50 000
Inventory
200 000
Cash at bank
40 000
Buildings
200 000
Retained profits
90 000
Accounts receivable
90 000
2 The company did not declare any dividends during the year. Its balance in retained profits at the start of
the year was $70 000. What is the profit for the year?
Get Complete eBook Download By email at student.support@hotmail.com
31
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
PROBLEM 1.9
Contents of financial statements
Match each item with the financial statement it would appear in by ticking the appropriate column.
Item
Balance sheet
Income statement
Statement of cash
flows
Wages expense
Cash paid for equipment
Cash at bank
Equipment
Cash flow from customers
Accounts payable
Cash paid to employees
Sales revenue
PROBLEM 1.10
Comparing net profits and cash flow
Kingsford Customs was founded on 1 July 2022. At the end of the first year’s operations, the following
summary of its activities has been prepared by the owner.
1 Borrowed cash of $60 000 from CAA Bank.
2 Employees earned $96 800 of wages, of which $40 000 is to be paid in the next accounting period.
3 Performed customised services that generated sales revenue of $243 300, of which $100 000 remained
uncollected at the end of the year.
4 Other operating expenses, including phone bills and electricity amounting to $26 800, were incurred during
the year. Of this amount, $10 000 remained unpaid at the end of the year.
Show the effect on net profit (ignore interest expense) and cash of each of the transactions for this
accounting period.
PROBLEM 1.11
Contents of financial statements
Match each item with the financial statement that it would appear in by ticking the appropriate column.
Item
Asset
Liability
Shareholders’
equity
Revenue
Expense
Inventory
Cleaning expenses
Cash at bank
Marketing expenses
Buildings
Income taxes payable
Loans from banks
Accounts payable
Retained profits
Accounts receivable
Income tax expense
Cost of goods sold
Sales revenue
32
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
PROBLEM 1.12
Classification of items
Listed below are balances for 2022.
$
Accounts receivable
100 000
Sales
250 000
Electricity
30 000
Retained profits
70 000
Loan
200 000
Transportation costs
10 000
1 Classify each account as an asset, liability, revenue, expense or equity.
2 Prepare an income statement for the period ending 31 December 2022.
PROBLEM 1.13
The accounting equation
Cardigan Ltd has total assets of $150 000 and liabilities that add up to $70 000 as at 30 June 2021.
1 What is Cardigan’s shareholders’ equity as at 30 June 2021?
2 During the year to 30 June 2022, Cardigan’s total assets increase by $63 000 while total liabilities increase
by $25 000. What is the amount of Cardigan’s shareholders’ equity on 30 June 2022?
3 Now assume that in the year to 30 June 2022, Cardigan’s total liabilities increase by $20 000 and its
shareholders’ equity decreases by $12 000. On 30 June 2022, what is the level of Cardigan’s total assets?
4 Assume that in the year to 30 June 2022, Cardigan’s total assets double while its shareholders’ equity
remains unchanged. What are its total liabilities as at 30 June 2022?
PROBLEM 1.14
The accounting equation
Use the accounting equation to answer the following questions.
1 Pillow Ltd halved its liabilities during the year. At the beginning of the year, the amount of total assets was
$80 000 and owners’ equity was $50 000. What is the amount of Pillow’s total liabilities at the end of
the year?
2 Buffalo Ltd began the year with assets of $60 000 and liabilities of $25 000. Net profit for the year was
$43 000. What is the amount of owners’ equity at the end of the year?
3 During the last financial year, Sparkle Industries tripled the amount of its assets. At the end of the year, total
liabilities amounted to $57 000 while owners’ equity was $15 000. What was the amount of total assets at
the beginning of the year?
PROBLEM 1.15
Matching financial statement items to statement categories
Raindrop Holdings Ltd is a public company. Listed below are items taken from its recent balance sheet and
income statement. Mark each item in the following list as an asset (A), liability (L) or shareholders’ equity (SE) that
would appear on the balance sheet, or revenue (R) or expense (E) that would appear on the income statement.
1 Property, plant and equipment
2 Sales revenue
3 Trade and other payables
4 Advertising costs
5 Provisions
Get Complete eBook Download By email at student.support@hotmail.com
33
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
6 Inventories
7 Prepayments
8 Borrowings
9 Reserves
10 Cash and cash equivalents
11 Depreciation
12 Cost of goods sold
PROBLEM 1.16
Income statement
Given the following information, prepare an income statement for PK Ltd for the year ended 30 June 2022.
$
Sales
700 000
Cost of goods sold
400 000
Rent expense
60 000
Wages
150 000
Advertising
50 000
Training expense
18 000
PROBLEM 1.17
Income statement
Given the following balances, prepare an income statement for the year ended 30 June 2022 for Bush Traders.
$
Sales
480 000
Cost of goods sold
210 000
Wages
80 000
Electricity
40 000
Travel
20 000
Advertising
10 000
PROBLEM 1.18
Analysing revenues and expenses and preparing an income statement
Assume you are the owner of Double Café, a coffee shop in Sydney’s CBD. At the end of June 2022, you find
(for June only) this information:
1 Sales, as per cash register records, of $47 000, plus sales on credit (two birthday parties) of $750.
2 The cost of goods sold during June had cost $16 000 consisting of coffee, cups and cakes.
3 During the month, according to the cheque book, you paid $14 000 for salaries, rent, advertising and other
expenses; however, you have not yet paid the $680 monthly bill for electricity for June.
On the basis of the data given (disregard income taxes), what was the amount of net profit for June? Show
computations.
34
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
PROBLEM 1.19
Calculate shareholders’ equity
GT Limited has the following assets and liabilities.
$
Cash
200 000
Loan
300 000
Accounts payable
220 000
Accounts receivable
340 000
Equipment
400 000
1 Classify each balance as an asset or a liability.
2 Calculate shareholders’ equity.
PROBLEM 1.20
Calculate shareholders’ equity
Given the following information relating to Stripes Ltd, what is the balance of shareholders’ equity?
$
Land and buildings
2 800 000
Accounts payable
250 000
Cash and cash equivalents
340 000
Inventory
410 000
Bank loan
600 000
Taxes payable
104 000
PROBLEM 1.21
Matching cash flow statement items to categories
The following items were taken from a recent cash flow statement. Note that different companies use slightly
different titles for the same item. Mark each item in the list as a cash flow from operating activities (O),
investing activities (I) or financing activities (F).
1 Cash paid to employees
2 Cash borrowed from the bank
3 Cash proceeds received from sale of investment in another company
4 Income taxes paid
5 Repayment of loan principal
6 Cash received in return for issue of share capital
7 Cash received from customers
8 Purchases of property, plant and equipment
9 Cash paid to suppliers
10 Cash paid for dividends to shareholders
PROBLEM 1.22
Accounting assumptions
Consider the following statements relating to how we might account for certain transactions or events. What
accounting assumption or principle underlies each?
1 ‘Accounting financial statements are primarily based on historical costs.’
Get Complete eBook Download By email at student.support@hotmail.com
35
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
2 ‘At the end of each period, a company has to calculate any salaries that have accrued, and recognise an
expense and a liability for that amount.’
3 ‘If a company changes its depreciation policy, it needs to disclose (in the notes to the financial statements)
the nature of the change, and its financial effects.’
4 ‘If a company issues new shares this is recorded in the company’s books. However, a sale of the company’s
shares from one shareholder to another is not.’
PROBLEM 1.23
Qualitative characteristics
The Framework for the Preparation and Presentation of Financial Statements examines the characteristics of
accounting information that make this information useful for decision-making. It also points out that various
limitations, which are inherent in the measurement and reporting process, may necessitate trade-offs between
these limitations and the positive characteristics of useful information.
1 Briefly describe the following characteristics of useful accounting information:
a relevance
b faithful representation
c
understandability
d comparability
e
timeliness
f
verification.
2 For each of the following pairs of information characteristics, give an example of a situation in which one of
the characteristics may be sacrificed in return for a gain in the other:
a relevance and verification
b faithful representation and timeliness
c
comparability and relevance
d relevance and understandability.
CASES
CASE 1A
Woolworths Limited
Refer to the extracts of the 2021 annual report of Woolworths Limited (https://www.woolworthsgroup.com.au/
icms_docs/195984_annual-report-2021.pdf) in the book’s appendix. All questions relate to the consolidated
accounts.
1 On what date does Woolworths’ most recent reporting year end?
2 For how many years does it present complete:
a balance sheets?
b income statements?
c cash flow statements?
3 Provide indicators that Woolworths uses accrual accounting.
4 What were total assets at 27 June 2021?
5 What were total liabilities at 27 June 2021?
6 What was shareholders’ equity at 27 June 2021?
7 State the accounting equation in dollar figures at 27 June 2021.
8 What was the net profit before tax for 2021?
9 What was the net profit after tax for 2021?
10 What were the largest cash inflow and outflow relating to operating activities?
11 Give two reasons why the cash flow from operations is a different figure from operating profit after tax.
12 Did its total assets increase or decrease over the last year?
13 How much inventory (in dollars) did Woolworths have as at 27 June 2021?
36
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
14 Are its financial statements audited by an independent firm? Who is the auditor for the company?
15 What information would Woolworths’ investors and lenders be most interested in?
16 Provide examples of the accounting principles of materiality and comparability from note 1 of the accounts.
CASE 1B
Accrual and cash profit in measuring performance
Wings Ltd is an airline services company with a plant near Sydney Airport and service centres in several states.
It provides meals, serviettes and other food-related items, cleaning, interior maintenance and several other
services to various airlines. The company has been fairly successful, though recessions and the deregulation of
air services have put significant pressure on its operations. When the company began in the late 1990s, it had
a relatively weak financial position (mainly because of borrowing to get set up) and its financial performance,
while satisfactory, has not enabled it to reduce its debt load very much. It seems that every time the company
gets a little ahead, new equipment must be purchased or new product lines developed, and the company
finds itself borrowing again.
A recent year provides a good example. The company’s accrual profit was $188 000 and its cash profit was
$241 000. (The difference resulted because of a depreciation expense of $96 000 and uncollected revenue
being $43 000 higher at the end of the year than at the beginning. In the company’s financial statements, the
phrase ‘net profit for the year’ was used to describe the accrual profit and ‘cash generated by operations’
described the cash profit.) The CEO had looked forward to using some of the cash to pay debts, but late in
the year the company had to buy new food-handling and wrapping equipment for $206 000 to meet revised
standards announced by its airline customers. Therefore, the company ended up only a few thousand dollars
ahead in cash, not enough to make much of a dent in its debts.
The CEO has a regular half-yearly meeting with the company’s external auditor to discuss accounting and
auditing issues. After the results were known, the CEO phoned the auditor and made the following comments:
‘I thought I’d ask you to think about a few things before our meeting next week. When it comes to our
accounting, I think the company has too many masters and too many measures. What I mean is first that too
many people are concerned with what our financial statements say. Why can’t we just prepare financial
statements that meet my needs as CEO? Why do we have to worry about all the other people outside the
company? Sometimes I’m not even sure who all those other people are, since you accountants and auditors
often just talk about ‘‘users’’ without being too clear what you mean. Also, I’m confused by the existence of
both a ‘‘net profit’’ figure and a ‘‘cash flow from operations’’ figure in our financial statements. Why can’t we
just have one or the other to measure our performance?’
The CEO raised issues that will be addressed frequently as this book develops your understanding. But for
now, what would you say to the CEO?
CASE 1C
Audit and ethics issues
Assume you were reading an article on the auditing profession in a professional accounting magazine that
included terms such as independence and auditors’ responsibilities. It also noted that there was a large
standards expectation gap between auditors and users of financial statements.
1 What is meant by independent assurance?
2 Give some examples of lack of independence.
3 What does the ‘Expectation Gap’ refer to?
4 How do management’s and auditors’ responsibilities differ?
5 Why is the integrity of management important to the financial reporting process?
HOW’S YOUR UNDERSTANDING? SOLUTIONS
1A
Financial performance and financial position.
1B
(i)
Cash profit: $100 000 – $60 000 = $40 000
(ii)
Accrual profit: $100 000 + $200 000 – $60 000 – $10 000 = $230 000
Get Complete eBook Download By email at student.support@hotmail.com
37
GetofComplete
eBook
Download
By email at student.support@hotmail.com
Fundamentals
accounting and
financial
management
1C
1D
(i)
A
(ii)
L
(iii)
Not listed in the balance sheet
(iv)
SE
(v)
A
(vi)
L
(i)
$60 000; $100 000 – L = $40 000
(ii)
$500 000; A = $200 000 + $300 000
(iii)
$40 000; $300 000 = $200 000 + $600 000 + RE
1E
NP: $200 000 − $90 000 − $60 000 − $10 000 = $40 000
RP: $80 000 + $40 000 = $120 000
1F
$100 000 + $60 000 − $40 000 = $120 000
PRACTICE PROBLEM SOLUTIONS
PRACTICE PROBLEM A
1
Account
Classification
Cash at bank
Asset
Inventory
Asset
Sales
Revenue
Wages
Expense
Cost of goods sold
Expense
Share capital
Equity
Accounts payable
Liability
2
Income statement
For the year ending 30 June 2022
$
Sales
3
210 000
Cost of goods sold
(70 000)
Gross profit
140 000
Wages
(40 000)
Net profit
100 000
Balance sheet
As at 30 June 2022
$
Assets
$
Liabilities and shareholders’ equity
Cash at bank
210 000
Accounts payable
30 000
Inventory
60 000
Share capital
140 000
Retained profits
100 000*
270 000
270 000
*Opening retained profit + profit–dividend = closing balance retained profit (0 + 100 000 − 0 = 100 000) *
38
Get Complete eBook Download By email at student.support@hotmail.com
Get Complete eBook Download By email at student.support@hotmail.com
CHAPTER 1: Introduction to financial accounting
PRACTICE PROBLEM B
1 Accrual profit
= total sales – total expenses
= $750 000 + 260 000 – 580 000 – 240 000
= $190 000
2 Sales revenue
= 2000 × $8
= $16 000
Cost of goods sold = 2000 × $5
= $10 000
PRACTICE PROBLEM C
Shareholders’ equity = Assets – Liabilities
= (Property, plant and equipment $1 500 000 + Accounts receivable $400 000 + Cash
$100 000 + Inventory $500 000) – (Bank loan $250 000 + Wages payable $90 000)
= $2 500 000 – 340 000
= $2 160 000
Get Complete eBook Download By email at student.support@hotmail.com
39